Bond Markets Expect More Inflation On Deficit Fears

| About: ProShares Inflation (RINF)

Bond yields rose since the election, indicating that market expectation are for higher inflation and higher credit demand in the coming year or so.

To gauge inflation expectation, we look at the inflation-indexed 10-year bonds, which rose in yield by 29 basis points (hundredths of one percent) in the past week. Similar increases occurred with other maturities. That tells us markets expect more inflation. Thirty basis points is not a lot more inflation, but such a change in expectations in one week is pretty big. It's also odd in that gold is down six percent in price over the same time period and other commodities have been generally flat in price.

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The total increase in yield was 42 basis points for the non-indexed 10-year bond, with similar gains for nearby maturities. Subtracting the increase in inflation expectations gives us a "real" interest rate increase of 13 basis points. Either demand for credit is expected to rise, or supply of savings is expected to fall. Generally, credit demand is far more variable than supply of savings, so I'm interpreting the change to be on the demand side.

What is the story behind expectations of rising demand for credit? It most often is a growing economy, in which consumers and businesses borrow more because times look good. It could also be expectations of rising federal deficits, which make sense given Donald Trump's campaign promises. (See my article "President Trump's Policies Will Likely Slow Economic Growth Over The Next Two Years.") Although I expect weaker growth (but not a recession) as a result of the changeover in administrations, my colleagues in the economic forecasting profession have a rosier view, as evidenced by The Wall Street Journal's Economic Forecasting Survey. The economists surveyed made little change to their 2017 outlook but boosted projections for 2018 by an average of one-quarter of a percentage point. That would be enough, if typical of investor opinions, to boost interest rates now in expectation of higher demand for credit in the future.

If, however, investors believe Bill Conerly that the economic outlook has declined a small amount, then interest rates are higher on greater deficit predictions, consistent with Donald Trump's campaign promises for tax cuts. Reducing marginal tax rates is good for economic growth, but not good enough to pay for the tax cut in the immediate future.

The rising deficit is the most likely trigger for both of these moves in interest rates. Many people still believe that rising deficits are inflationary (though I say that's true only sometimes). And everyone believes that government purchases of bonds can push up interest rates, all other things equal.

Markets are not perfect seers, but they are worth paying attention to.