The Coming Inflation: Bond Yields Up And U.S. Dollar Down

Summary

• Jeremy Siegel writes that "Higher Inflation is Coming" and the bond market and the foreign-exchange market seems to feel the same way as inflationary expectations rise.
• M2 measure of the monetary stock rose in 2020 at its highest rate in 150 years, the Fed is supportive of higher-than-target inflation, and fiscal stimulus is on its way.
• This, according to Mr. Siegel, can only result in bond prices dropping, so bond holders beware, while the U.S. dollar drops in value, watch out dollar holders.
• Stock holders will find this favorable, however.

Jeremy Siegel, professor of Finance at the Wharton School, University of Pennsylvania says it all. The title of his piece in the Wall Street Journal carries the message: “Higher inflation is coming.”

I certainly do not expect hyperinflation, or even high single-digit inflation. But I do believe that inflation will run well above the Fed’s 2 percent target, and I will do so for several years.

The reason for this?

Between March and November, the measure of broad-based money supply, M2, jumped by a sharp 24 percent. Shockingly, the money supply surge in 2020 exceeded any in the one-and-a-half centuries for which we have data.”

And the new Biden administration will surely provide even more fiscal stimulus.”

This is quite a picture.

Markets Have Already Begun Reacting

Mr. Siegel focuses on the bond market.

It will be the Treasury bondholder, through rising inflation, who will be paying for the unprecedented fiscal and monetary stimulus over the past year.”

Well, the inflationary expectations built into bond yields have been rising.

After several years of being relatively benign, these inflationary expectations have risen from underneath 1.80 percent in late November to just over 2.10 percent at the current time.

Thus, 10-year inflationary expectations have risen by more than 30 basis points in less than a month and one half.

For the 5-year note the rise has been more than 40 basis points.

Thus, market participants have built into the bond market their expectation that inflation will take off within the next five years and then continue at a higher rate for the next five years. Note, however, that as with Mr. Siegel’s forecast, the inflation is not expected to turn into runaway inflation, but will be higher than the Fed’s 2 percent target.

Furthermore, the value of the U.S. dollar began declining at around the same time, late November 2020.

At the end of November, it took a little less than $1.1900 to purchase a Euro. The U.S. Dollar Index (DXY) was about above 92.0.

On January 6, 2021, it took over $1.23 to buy a Euro and the U.S Dollar Index was below 89.5.

The fiscal and monetary future of the U.S. seemed to be impacting the foreign exchange markets as well.

And, even though the dollar has recovered slightly since January 6,

Speculative bets against the dollar have build up to their highest level in nearly three years, as bears cling to their view on the currency despite its near 1 percent rebound this year.

This according to Eva Szalay of the Financial Times. Her reasoning is very much like that of Mr. Siegel. Monetary policy is too easy and the fiscal plans of the Biden administration will only add to the pressure on prices.

Ms. Szalay quotes one expert who expects to see the Euro to cost $1.27 by the end of the first six months of the year. The speculators, this expert thinks, are right.

What Might Save Us From This Inflation?

But, the experts might be wrong. They have been wrong in the past, just look at what happened during the last period of economic expansion.

Following the Great Recession, the Federal Reserve came out of the gate with a very expansive monetary policy. Fed Chair Ben Bernanke, a student of the Great Depression of the 1930s, was not going to let monetary policy lag in attempting to produce a recovery, and so he did what he felt was necessary in order to get the economy going again and keep it going.

There was, during the recovery three rounds of quantitative easing, and Bernanke was always careful to signal that if the Fed erred at this time, it was going to be on the side of too much monetary ease than too little.

The experts said whoa, such an effort was going to set off the inflationary bells.

But, as Mr. Siegel notes,

Despite warnings by many economists then of rising consumer prices, inflation did not follow, and actually declined.”

My story from here is a little different from that of Mr. Siegel. His view can be read in the Financial Times article cited above. My position can be read a recent post.

Mr. Siegel does not believe that consumer prices will refuse to rise at this time. Consumer price inflation will take off, although not excessively. I am not so sure.

So, Is The Market Wrong?

Certainly for the short run, watch the bond markets, and watch the foreign exchange markets. Also, watch the stock market because it has been closely tied to the largess of the Federal Reserve System over the past eleven years or so.

What happens over the next six months are so can have significant effects on investors. Mr. Siegel has some concern for bondholders. The interest rate on bonds is going to rise, resulting in declining bond prices.

The value of the U.S. dollar will fall in this scenario.

But, the government is moving ahead in order to protect the individuals that have been hard hit by the pandemic and the economic recession.

With the fiscal stimulus and the easy money, the stock market should continue to rise.

This, at least, is what Mr. Siegel thinks will occur.