What Is the Bond Market Trying to Tell Us?

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.

Comments

[Bruce Vande...:]

TBT is telling us that the US government is reaching its bailout limit. The more bailouts we have the higher it will go.

May 26 03:51 PM

[wdhalgren:]

"There's also some debate about whether the Fed will have the discipline to do the right thing when the time for action arrives."

Really? You mean like a two sided debate where someone is actually taking the position that the fed will act responsibly and reveal that our economic growth has been a facade and we face declining living standards for the forseeable future? Someone who actually believes that the fed will take away the punch bowl before the next bubble has a chance to get started, much less firmly entrenched? Someone who posits that our fed intends to make sure that the US government pays its $60 trillion in current and future obligations in real dollars, despite the fact there is no way we can generate that kind of capital from the private sector to fund those obligations, much less the new programs still being dreamt up by our ever growing public sector? Someone who believes that the record levels of household debt will also be paid down in real dollars, thanks to the diligence of Ben Bernanke in protecting the vehicle to which we savers have entrusted the fruits of our labors, the mighty US dollar?

Huh. Interesting. Do you have a link?

May 26 06:47 PM

[smart as paint:]

the bond market is telling us they are as foolish as ever. there is no inflation as far as the eye can see, and the feds can't print nearly enough money to keep up with wealth destruction, the only problem is i may be insolvent before the bond market wakes up.


On May 26 03:51 PM Bruce Vanderveen wrote:

> TBT is telling us that the US government is reaching its bailout
> limit. The more bailouts we have the higher it will go.

May 26 06:48 PM

[Mad Hedge F...:]

That bonds are expensive. One of my core positions, the PowerShares Lehman 20 Year 200% short ETF (TBT), a bet that benefits from falling long Treasury prices, hit a new high for the year today at $54.50. Long time readers of this column got into it in December at $35. The ripple effects of last week’s US downgrade chatter is still feeding into prices, exacerbated by another huge slug of new issuance this week. Treasury futures got slammed, gapping down two points to 118 3/4, and are off a breathtaking 20% from the recent peak. I think the downgrade talk is premature, and the inflation rationale for this trade is still years off. The news about another North Korean nuclear test is just noise. But when a security is as accident prone as Treasury bonds, you never know which of the panoply of negative surprises is going to hit first. I think the bond bubble has popped, and that the TBT could eventually spike to $200.

May 26 08:41 PM

[reluctantQuant:]

treasuries are in a serious sell off, not a great shocker. check price slips in the 10yr note future. repo on WI 5yrs for month last at -0.15. Street is going massively short, look for continued fade till mid june, then solid rally potential. happy TBT holders might consider taking their happy profits to the bank soon. don't look at tips break even too much when yield beta is going out of whack...

--rq (in a rush today).

May 27 08:44 AM