Bonds and the Fed are still far behind the curve
For more than a year, I argued that monetary policy was far too easy and therefore the risk of persistently higher inflation was very high. (Check out my posts over the past year in the blog archive on the left.) With consumer price inflation now approaching double-digit territory, the bond market is beginning to gain momentum (as recently as last January, I noted that the bond market was unable to grasp). The following charts show that it is only in the past two months that the bond market has started to adjust to a reality of higher inflation; Unfortunately, there are still a lot of adjustments to be made.
Chart 1 shows the long-term history of bond yields and inflation. Although the recent rise in yields has been quite strong, yields are still an order of magnitude lower than they should be if inflation is indeed persistent.
Chart #2 adjusts the yield on 10-year Treasury bills for the rate of inflation. Real yields have never been so low. This means that bond investors are beginning to realize that owning bonds is a great way to lose substantial purchasing power. How long will it take for bonds to at least compensate investors for inflation? By similar logic, anyone who borrows money at recent interest rates has made a killing if they used the borrowed money to purchase real assets (e.g. property, businesses, commodities) .
Chart 3 shows the national average 30-year fixed rate mortgage rate. It has gone from 3% to now 5.25% in a very short time, but it is still well below the rate of house price inflation, which has been in double digits for the past year or two. Lesson learned: buying homes with leverage at current mortgage rates can be extremely profitable. This lesson will translate into more demand for homes and more borrowing, which will only exacerbate the inflationary fundamentals at work in the economy today. It will also erode the demand for money, which will effectively force the Fed to raise rates even further.
Chart #4 compares the strength of the dollar against other major currencies (blue line, inverted) with non-energy commodity prices. This chart is actually quite interesting because the typical correlation between the dollar and commodity prices has completely broken down: previously, a weaker dollar was correlated with higher commodity prices; now it seems that the stronger the dollar, the higher the prices of raw materials. This can only mean that artificially low interest rates are boosting demand for durable assets, but they are not weakening the dollar, perhaps because most major currencies have unusually loose monetary conditions. The dollar is mainly benefiting from its appeal as a safe haven.
Chart 5 compares the nominal and real 5-year Treasury bond yields (red and blue lines) with the difference between the two (green line), which in turn is the market’s expectation for the average of the CPI over the next 5 years. Inflation expectations have indeed increased and are now at a historic level (remember that the TIPS was only introduced in 1997). But the market only expects inflation to average slightly below 3.5%, well below the 11% annualized rate we’ve seen in the first three months of this year. In other words, the bond market expects a significant decline in inflation in the coming years.
But since the Fed hasn’t even started to tighten, that’s a pretty brave assumption.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.