For a brief, shining moment, there was convergence. Now there's confusion.
The bond market isn't taking any chances. Yes, deflation's a risk, but judging by the sentiment among traders in government IOUs, expectations appear to be moving ever so slightly toward the bias that the Fed will be successful in its quest to elevate inflation from the grave.
The jury's still out on that score, at least in terms of timing. And that may make all the difference if you're a trader. In any case, the 10-year Treasury Note closed above 3% on Friday, an act of defiance to conventional wisdom that we haven't seen since November, according to numbers from the U.S. Treasury's web site. Meanwhile, the yield on the 10-year inflation-indexed Treasury has inched lower, staying below 2.0% since early January. The result: Inflation expectations are on the rise, moving above 1% this month for the first time since October.
For the moment, the opportunity to buy a 10-year TIPS at virtually no extra cost over its conventional counterpart looks like a train that passed by. As we've discussed, hopping on board the train when it was in the station looked like a no-brainer to some degree, in part because such events rarely happen. Indeed, it's not supposed to happen. Mere mortals are supposed to pay extra for the privilege of hedging future inflation. If you'd rather not, conventional Treasuries will suffice, albeit at the risk of ending up on the losing side of higher future inflation, if any — the bane of unhedged fixed-income securities everywhere.
Yes, the fleeting stretch of convergence now looks like a buying opportunity— hindsight never fails to tell us what we should have done. The question now is whether the parting of the ways for nominal and real Treasury yields is a sign of things to come or just another bout of volatility as the world comes to terms with deflation and recession?
We don't have a no-risk answer, but here's what it looks like from our vantage: in a word, politics. The Obama administration is poised to unveil the next critical step in its efforts to soften the credit crisis and otherwise help return something akin to normalcy to the American economy. It's unclear if upping the ante for bailing out the banks will make a significant dent in the various financial ills that afflict the country, but the White House is going to give it the old college try. That's in addition to the huge fiscal stimulus plan being worked out in the Senate. Considering the world afterward is a reasonable exercise, and so we have some of the motivation for selling Treasuries.
In the best of circumstances, this political high-wire act would keep a bond investor worth the name on pins and needles. But the stakes are especially high and the circumstances are less than perfect. Unsurprisingly, some fixed-income types appear to be getting cold feet, at least for the moment, and so the path of least resistance is arguably selling nominally priced Treasuries. How could it be otherwise until and if fresh evidence of deflation comes our way. With no pricing news to speak of, traders look elsewhere for guidance. What they find is a lot of discussion and debate about what comes next in Washington.
As Bloomberg News reports, "Banks are 'looking for clarity, we’re looking for this to be the complete package,' said Wayne Abernathy, an executive vice president at the American Bankers Association. 'If they [the Treasury Department] don’t have the details spelled out they will just freeze the market.'"
If so, better to sell first and analyze the details later. For the moment, at least, there are no details. Treasury Secretary Timothy Geithner delayed the announcement of the new bailout plan — originally scheduled for today — to tomorrow. Meanwhile, everyone's placing bets and making forecasts. Will the new plan work? What if it doesn't? And how is all the monetary stimulus going to affect future inflation? Lots of questions, lots of debate. Answers to come. Some of them may even be as expected.