You thought the concern for inflation had been "put to bed."
Well, think again. A thought-piece by David Rosenberg in the Financial Times attempts to put the issue back on the table with the statement "Don't Bet Against Bernanke's Quest for Higher Inflation."
Inflation helps to build wealth to push consumption spending. Inflation helps to increase profits to push investment expenditures. And inflation reduces the real value of debt so that the burden of huge liabilities is minimized. All sounds good, doesn't it?
So there is purpose to QE1 and QE2 and QE3. And, maybe the talk of tapering is just a ruse.
What is the case that Mr. Rosenberg makes?
Well, it took Paul Volcker "four to five years" to break the back of inflation and once inflation was broken in 1981, the secular bull market in bonds began.
Mr. Bernanke has only been at quantitative easing for just four years…the fifth year in this cycle only began in two months ago in July. "No doubt it has taken Mr. Bernanke far-longer to dispel deflation concerns, but I (Mr. Rosenberg) believe he will ultimately be successful in his quest for higher inflation…."
Mr. Rosenberg wonders whether or not we have now begun a new, secular trend in the bond market, only this time it will be a bear market.
If so, he argues, the bear market began in May as United States interest rates seemingly bottomed out and began to move upwards.
Now, the 10-year Treasury bond is yielding slightly below 3.00 percent and with the 10-year TIPS yielding just over 80 basis points we have a "real yield" on these longer-term securities for the first time in over two years. Thus, the inflationary expectations built into the market rate of interest is a little more than 2.00 percent.
But, the real interest rate is expected to reside a little closer to the expected real rate of growth of the economy. The last two quarters saw the growth rate of real GDP below 2.0 percent with the rate of increase from the second quarter of 2013 being 1.6 percent, year-over-year, and with the first quarter registering 1.3 percent.
Although these rates of growth are expected to rise to the 2.00 percent to 2.50 percent range, Mr. Rosenberg argues that the overall scenario we are headed into is one of "stagflation" so that overall economic growth will not rise into the 3.00 percent range during this period of recovery.
Analysts keep looking for indications that the economy is going to achieve faster rates of growth over the next year or two, but we have to remember that the current economic recovery has entered its fifth year and that the underlying structure of the economy seems to be telling us that there are significant dislocations in the economy that will require a major re-structuring of things before these earlier, higher rates of growth can be achieved.
Just two of the signals here are the labor participation rate which has fallen back to the level it was at back in 1978 and the rate of capacity utilization in manufacturing is peaking out in this cycle at around 78 percent of capacity, the lowest cyclical peak on record since the late 1960s. I have written many posts over the past two years about this structural problem, the latest was posted in the middle of August.
Anyway, if the TIPS yield moves up to the lower end of the expected growth rate of the economy, say 2.00 percent, this would mean that the nominal yield on the 10-year Treasury note would have to rise to at least 4.20 percent. But, this is only a start.
Mr. Rosenberg argues that in order to get what it wants the Bernanke Fed will have to continue its efforts at quantitative easing "until the Fed gets what it wants-which is inflation expectations heading up to 2.50 percent." Thus, the yield on the 10-year government note would have to move up above 4.50 percent.
Bond prices, if this scenario is true, will have to decline significantly to get the rate up to this level.
But, that is not all. To have a secular bear market inflation would have to grow and the inflationary expectations built into the yields on Treasury securities would have to rise.
How soon would this happen and how far will the increase in inflationary expectations go?
Such a scenario will not happen over night. My belief is that the yield on the 10-year Treasury note will get up into the 4.00 percent range in the summer of 2014 ... at the earliest.
The question is, when will financial market participants begin to pick up hints that actual inflation is really beginning to rise? Mr. Rosenberg believes that "core inflation has bottomed out." He specifically points to the "August employment report, specifically the private sector wage bill, which jumped 0.7 percent and is up at a 6.00 percent annual rate over the past three months."
While analysts are still looking for any sign they can find to indicate that the economy is starting to grow more rapidly, the suggestion here is that analysts also need to begin to look for signals that wage and price pressures are starting to build…even modestly. And, if the structural problems in the economy are really severe, inflation will pick up in spite of slow economic growth and high levels of under-employment.
Therefore, a very important piece of information that people need to be cognizant of is the rate of inflationary expectations that are built into Treasury interest rates. If investors start to see inflationary expectations climb then they need to build this into how they structure their portfolios.
Such a move, of course, "is more bad news for pensioners and those who live on fixed-income investments." And, in terms of equity investments, "It also means screening in the equity market for companies that benefit in a moderate stagflationary environment, namely those with the capacity to pass on cost increases to protect profit margins."
The other thing is that if you are an issuer of bonds, the time to begin to move starts right now. Is this what Verizon is seeing? Check out "Verizon Pitches Blockbuster Bond."
So, Mr. Bernanke, during his tenure at the Federal Reserve, has pitched the financial markets a monetary policy that is historically unique. Many analysts have wondered all along whether or not the actions of the Fed curing his time will result in a period of massive inflation consistent with the massive injection of funds that have reached the banking system. During this period, Mr. Bernanke and other officials at the Fed have argued that they will always have time to reverse their path and remove the excessive liquidity when needed.
The question Mr. Rosenberg is raising is a valid one. Could we be entering a period of inflation ... even a period of stagflation? Could we be entering a bear market in bonds? While we are watching everything else, maybe we should be watching this possibility as well. It takes monetary policy actions a long time to work themselves out ... sometimes longer than others.