What Is the Bond Market Trying to Tell Us?

Includes: BIV, TBT, TIP, TLO, TLT
by: James Picerno

In absolute numbers it's easy to shrug off, but the trend appears to have gained new momentum over the past week or so.

We're talking here of the spread between the nominal 10-year Treasury Note and its inflation-indexed counterpart, a.k.a., the 10-year TIPS. The yield difference between these two securities is one of the more widely watched market-based forecasts of inflation. It's not infallible, but neither is it irrelevant. It does, however, offer a real-time measure of the crowd's outlook for inflation and as our chart below suggests, the market seems to be growing increasingly anxious.

In absolute terms, of course, it still looks trivial. The current 10-year inflation forecast of 1.73% is, by historical standards, quite low. And as the chart above reminds, we're still quite a ways from the 2.5% forecast that prevailed before all hell broke loose last September.

Nonetheless, strategic-minded investors should keep an eye on the trend, which at the moment is decidedly on the rise. Much of the increase in the inflation forecast comes from selling the nominal 10-year Note, which drives the yield higher. Last Friday, the conventional 10-year closed at 1.72%, up from less than 1% in mid-March.

The trend is hardly surprising. We've known all along that the Federal Reserve is intent on raising inflation to fend off the risk of deflation. That's been a wise policy, but it shouldn't be written in stone. The great question is when to turn off the liquidity machine? For the moment, the risk of acting too early and choking off any nascent recovery seem roughly balanced with the danger of letting inflation out of the bag by letting the liquidity injections run on too long. But balancing acts have a finite lifespan.

It's still too early to make definitive decisions, but the capital and commodity markets seem to be telling us that pricing pressure is no longer benign, as the buoyant markets so far this year in gold and TIPS suggest. If true, the next question: Are the so-called green shoots of economic recovery robust or simply a mirage? Unclear at the moment, and it's likely to stay that way for some time.

Definitive answers about the economic cycle are always ambiguous in real time. Normally, that's not a problem because the stakes aren't usually so high in managing the business cycle. But this time around, there's enormous pressure to jump start the economy after such a dramatic economic implosion and so the monetary and fiscal tools have been deployed to an extraordinary degree. The prospective risk of inflation, then, may be unusually high — unless the central bank puts on the monetary brakes at the appropriate time. The trouble is that no one's really sure of timing. There's also some debate about whether the Fed will have the discipline to do the right thing when the time for action arrives.

Lots of questions, but at the moment bond traders don't appear willing to sit around and hope for the best.