Is Rising Inflation Creating a Headwind for Long Bonds?

I have alerted readers in two recent posts (US Long Bonds in Injury Time and Watch the Stock/Bond Ratio) that I was of the opinion that U.S. long-dated bonds were topping out.

The following chart of the U.S. 10-year Treasury Note yield indicates that we have now arrived at an important point of resolve regarding an upward break of both the trendline and 50-day moving average:

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Source: StockCharts.com

Whereas safe-haven buying has driven long bond yields sharply lower ever since the advent of the sub-prime crisis, investors now seem to have started focusing more strongly on the inflation outlook rather than on economic growth considerations. And rightly so, as the latest batch of statistics points to rising inflation around the globe.

It would appear that financial markets currently face three potential price pressures, as succinctly summarized by GaveKal:

1. Soaring food and energy prices

Whatever the reason may be, elevated food and energy prices are becoming a real concern. The price of rice, for example, has simply gone parabolic this year. In Bangkok, white rice is now up +120% YTD.

Meanwhile, oil reached yet another record high yesterday, closing at US$113.8/barrel. On that topic, we note with some concern that … world expenditure on oil, as a percentage of global GDP, is back to 7% - a level not seen since 1980. Given the severity of the global recession that followed in the early 80s, this data point does not instil confidence.

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2. Rising export prices from Asia

According to BLS data from March, import prices from China are now rising +4% YoY, highlighting a rise from negative growth only one year ago. Moreover, US producer prices are now rising faster than expected, up +6.9% in YoY in March. These are all signs that we are indeed witnessing a significant shift in the terms of trade between the East and the West, and all of this does not bode well for the US consumer, whose spending is already waning.

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3. Excessive monetary easing by central banks

Two months ago, the Fed was under great pressure to ‘get back on the curve’. With a couple of significant rate cuts and a series of other easing measures in mid-March, some say the concern is now that the Fed is easing too much – and that it could now be creating the next bubble, this time in commodities. However, we are hesitant to criticize the Fed in this respect when M1 growth remains non-existent (as it has been for the last couple of years) and monetary base growth is at a 7-year low.

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Although long bond yields may not yet skyrocket given the poor economic outlook, it seems prudent not to be exposed to an investment that will by definition lock in an unattractive total return of 3.7% over the next 10 years. As a matter of fact, it may not be a bad proposition to buy a few out-of-the-money put options on long-dated bonds.

Comments

[silverspring:]

Commodity price pressure is the one which will cause inflation anyway in medium term, therefore affects bond yield to go up in the similiar term (fight inflation!). Shorting 5yr bond and at the same time buying 2yr bond should give us positive MTM provided current credit crunch will continue for another year which forces Fed to ease overnight rate more. In short, play with the balancing process of inner force of Fed's rate easing and outter greater force of international commodity market.

2008 Apr 17 10:00 AM