Ever since the great recession and the Fed started QE, there have been two camps. One camp immediately concluded that QE was a massive money printing operation and that we were looking at imminent double-digit inflation. The second, so far correct, camp, has been that QE might be printing money, but the money would not leak into the real economy, and anyhow, we were looking at DEflation in the face of what could very well turning into a depression, so a little bit of inflationary pressure was fine.
As we can see above, QE vastly increased bank reserves in the US economy, with only a slight boost to overall currency in circulation. This meant the money created by QE was not immediately available in the general economy, and probably even more money than was created was sucked into bank vaults or otherwise destroyed due to a credit bubble popping. With this knowledge, it is not surprising that we did not see a substantial uptick in inflation.
Around the end of QE in 2014, reserves started decreasing, which continues to this day. At the same time, overall currency in circulation has risen to match as the economy has picked up. This is leading to a perfect storm of inflation, which I believe has been reflected in the bond market by rising treasury yields at both the long and short ends of the curve, especially the 10 year treasury. Combined with M2 velocity finally picking up some, this is a double-whammy for inflation going forward.
If bank reserves reverted to a pre-QE "normal" level, we are looking at an approximate doubling of currency in circulation over the next decade. With this in mind, I believe we should actually be looking at 3.5%+ on the 10yr, potentially up to 4% on the high end, due to increased inflation. Of course, this has other knock-on effects such as increased mortgage rates, which will reduce economic activity somewhat and temper this added inflation. We are also most likely near the end of the current economic expansion cycle and will likely have at least a small recession in the next 1-2 years, which is also deflationary. Regardless, we feel that though the market has been pricing in increased inflation, it has not yet fully priced in all of the effects and that could lead to more pain in the bond and equity markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.