Bonds: No Inflation Threat in Sight

The bond market appears sanguine about the inflation outlook. In my recent article Inflation Fears Are Overblown, I discussed how inflation pressures across the economy are largely under control. I also indicated how many disinflationary and deflationary forces were also at work that should cause lingering pricing pressures to subside in the months ahead. Based on the data, it appears that the bond market generally shares this view.

The bond market is typically very sensitive to any signs of inflation. While it is certainly an issue for stock investors, the threat of inflation is a paramount concern for the bond market. This is due to the fact that rising inflation erodes the value of the fixed income coupon payment provided by bonds. As a result, bond investors watch inflation signals very closely and will reacting swiftly by selling bonds given a mere whiff of prolonged inflation pressures.

Bond investors are signaling that recent inflation is not a cause for concern. Today is not the first time in history that we have experienced a dramatic and sustained rise in oil prices accompanied by a sharp increase in inflation expectations from consumers and the media. In the 1970s, we experienced two such episodes, first from 1973 to 1974 and then from 1977 to 1980 (see charts). During these past episodes, bond yields rose sharply along with oil prices, as fixed income investments were sold off heavily amid developing inflation crises. During the current oil driven rise in inflation, however, bond yields have actually moved lower, suggesting bond investors are currently not worried about any potential inflation threat.

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The bond market view on inflation is subdued for good reason. As discussed in my recent article Inflation Fears Are Overblown, wage pressures are virtually not existent, rising fuel and food prices are serving as a tax on consumers, and heightened global competition is deterring businesses from raising prices. Also, the disinflationary/deflationary impacts from the slowing economy along with declining housing prices should more than offset any inflationary effects of higher oil and food prices. While some understandable inflation jitters are likely to surface along the way, it appears that bond investors are on the most part feeling reassured that any lingering inflation signals should ultimately prove fleeting. The competence of global central banks provides further reassurance. Back in the 1970s, a prolonged mishandling of monetary policy compounded inflationary pressures. But since the early 1980s when Fed Chairman Paul Volcker broke the back of inflation, global central banks including the U.S. Federal Reserve are widely regarded as competent inflation fighters. As a result, the market has confidence that if a sustained inflation threat were to arise that the Fed and other central banks will act swiftly with the necessary steps to contain the problem. The recent decision on July 3 by the European Central Bank to fight inflation by raising interest rates despite concerns about weakening growth among many business leaders across the region supports this view.

Benign inflation does not suggest that bonds will move higher, however. While a more restrained inflation backdrop is certainly positive for the bond market, other factors must also be considered. For example, the Treasury market is currently trading at premium valuations with 10-Year Treasury yields below 4%. The corporate and high yield bond markets are working through a deteriorating earnings outlook and rising default concerns, particularly among financials and consumer cyclicals. And the problems facing the mortgage bond market have been well documented during the credit crisis over the last year. As a result, bond investors must still remain patient and selective.

But lingering inflation concerns are likely to present new trading opportunities in bonds. Inflation worries are likely to surface again in the months ahead, causing the bond market to sell off and potentially providing good entry points for new commitments. For example, those investors that stepped in and bought 10-Year Treasury bonds after yields had risen from below 3.50% in April to above 4.25% in early June have enjoyed a solid run, as yields have fallen back below 3.90% in the days since. New outbreaks of inflation jitters are likely to provide bond investors with attractive trading opportunities once again in the future. This assumes, of course, that the fundamental inflation backdrop has not materially changed along the way.

Conclusion: The bond market is signaling that a prolonged inflation problem is unlikely. While this does not suggest that bonds will make a sustained move higher, windows of opportunity caused by renewed inflation concerns are likely to surface for bond traders along the way.

Disclosure: No Long or Short Positions in Bonds or Bond ETFs

Comments

[Karsten:]

Actually, the inflation of the early 1970 was caused by the Vietnam war funding requirements and only aggravated by the first oil crisis. I find the observations in the article astuteand the consequences for markets in general are very positive which will be seen by year end.

2008 Jul 10 08:26 AM

[drbagel:]

Thank you, very interesting. I am concerned that the credit crunch is distorting the usual inflationary signals seen in the bond market. Investors have fled to treasuries for safety, pushing yields down. Much of the money currently in treasuries was in MBS and other credit products I dont understand and which did not exist during the last round of inflation. Perhaps this keeps the bond market from registering the inflationary trend.

I also wonder if destruction of wealth is really the same thing as destruction of money. Deflation would result from the destruction of money. When people lose money in property value they are losing wealth, not cash.

There is a fascinating disconnect between bond yields and commodity/gold prices. One of these is wrong. I dont know which.

2008 Jul 10 08:42 AM

[flatman:]

How about this theory - Investors have piled into Treasury's because many other fixed income investments do not make good collateral any more. So using current yields as an indicator of inflation is an invalid concept.

2008 Jul 10 08:44 AM

[User 143167:]

The conclusion is wrong. The bond yield is low because huge foreign demand of T bonds. It is not reflecting the inflation anticipation, but the willingness of foreigners to keep US(their biggest customer) solvent.

2008 Jul 10 10:21 AM

[carey_jim:]

The chart actually shows a similar lag between interest rates and inflation for the two previous periods also.

The Iraq war and Vietnam war are also both causes of inflation as all wars are (Revolutionary War, Civil War, World War I and II) Guns or butter?

As has been pointed out, in another comment, it is in the interest of the world to purchase US treasury debt to keep the United States solvent and to prevent the collapse of the dollar which might lead to world economic chaos.

The "flight to safety" into US Treasury issues is a historical reflex action which has less rational basis today than it has had in the recent past.

All of these factors point to a possible quick and severe correction of interest rates sometime in the future when the roadrunner realizes that he has, in fact, fallen off the cliff.

Is it rational to expect countries to loan money in inflationary environments when the currency they are purchasing is also losing value? Or is it state planning (socialism)?

Is it rational for United States citizens to purchase that same debt for rates that are below the official rate of inflation and which are FAR below the actual rate of inflation, hedonic factors aside of course, like the quality of television entertainment, hip hop and the movies?

The United States is not strong enough to try to set the dollar at .8 euros and 65 yen, for example, in another Breton Woods type declaration,, or even to "talk it up" over a two or three year period which they would like to be able to do.

That would be socialism anyway and we know socialism doesn't work. Or do we?

2008 Jul 10 12:08 PM

[carey_jim:]

Sorry, I meant 165 yen.

At this point it looks as if the US government wants both the yen and renminbi stronger and not weaker, however.

Bureaucratic minds are not easy to fathom.

2008 Jul 10 12:16 PM

[Edward Janeck:]

Markets are not always right, other wise there nobody would beat the market. One of the best trades right now is -short the 30 bond or if you like etf's short TLT.

2008 Jul 10 12:29 PM

[adan:]

interesting article, and really interesting array of comments !

maybe a follow up article (s) later re possible trading inflections?

thanks!

2008 Jul 10 01:01 PM

[Skjellifetti:]

The argument that rates are low and thus don't reflect inflation because there has been a "flight to safety" seems fishy. If you expect your "safe" investment to be eaten up by inflation, then it isn't really "safe", is it?

2008 Jul 10 02:20 PM

[secmaven:]

The quantity of money available that must be invested somewhere is at least double the amount relative to GDP growth since Volker pulled his high interest ploy. Plus, the float required to fund the GDP is less. In short, liquidity is way up and bonds become the beneficiary.

2008 Jul 10 08:37 PM