Team Transitory Lives! 12/21
The bond market still expects inflation to fade away
Recently, Paul Krugman conceded that inflation has been more persistent than “team transitory” had hoped for. Kudos to him for being forthright about it. In my Fantasy Intellectual Teams game, he would score an Open Mind point.
But there are some other members of Team Transitory who don’t write newspaper columns and instead play the forecasting game with real money. I am talking about investors in long-term bond markets. Reuters reported,
The Federal Reserve's more hawkish turn this week came amid heightened worries about economic recovery and inflation, but it has barely changed the bond market's view that short-term interest rates could top out below the U.S. central bank's estimated peak.
In the WSJ, James Freeman writes,
Lately in the United States, inflation has been outrunning the yield on the 10-year Treasury by more than five full percentage points. This brutal negative real return is worse than anything investors have received since an inflation event that really did prove to be transitory.
On December 16, the interest rate on 3-year Treasury securities was just under 1.0 percent. If you thought that inflation was going to average much more than 2 percent over the next three years, you would never invest in securities yielding just 1 percent. Instead, for example, you could invest in Treasury inflation-indexed securities, which protect you against higher rates of inflation. Even if you think that the Fed is going to use its magical powers to keep interest rates low in spite of inflation, you still would look for better returns.
Unless you think that there has been an outbreak of mass stupidity on Wall Street, you have to reckon with the fact that apparently the smart money believes that inflation is going to come down soon. Personally, I think that there has been an outbreak of mass stupidity on Wall Street. As Freeman puts it
Prices on U.S. government debt suggest that investors are supremely confident that inflation will soon decline and interest rates will stay low, even as the U.S. has lately become much more heavily indebted and therefore a more risky borrower—and just after the Fed proved it cannot accurately predict inflation. Who’s buying this stuff?
I am not gambling a lot of money betting that this outbreak will subside soon, but I am certainly not buying any three-year Treasury notes that aren’t indexed for inflation.
This is mistaking technically-motivated trading behavior for fundamentally-motivated trading behavior. Rates are low because traders understand that the central bank will defend the price point. No one has more ammunition than the Fed. It is a broken indicator because the "independent" central bank is, through open market operations, not even acting through intermediaries like it could, defending a high price.
The public discourse is polluted on this topic perhaps because many simlar types of price manipulation are illegal in regulated securities markets when done by a mere pleb. The Fed is wash trading bonds, but without the concealment that would normally accompany wash trading. In the most charitable reading of what the Fed is doing, they would counter that the openness of open market operations makes it distinctly different from crimes like market manipulation and wash trading.
So, in reading such arguments like the one you're writing, my objection internally is that you (and others writing similar arguments) typically do not address the elephant in the market, which are the open market operations. If you look at the recent and planned treasury buying activity published by the NY Fed, you have to ask yourself, do I or any reasonably conceivable band of bond vigilantes have more capital to blow than $50-$80 billion per month? https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/treasury-securities/treasury-securities-operational-details#monthly-details
Plus, there's good reason to believe that the member banks will join the NY Fed and others to defend the price point, because it's what the government needs. It's not just the prospect of 'fighting the Fed,' but fighting all the component banks as well who are all bound to one purpose: the suppression of systemic risk. The other issue with this argument that treasuries are an inflation indicator is that if they are, the correlation has badly broken down with the recent spout of highly correlated price increases. It's not actually stupid; you're just missing the fundamental factors driving this market. The prices accurately reflect the political arrangement here.
If we are looking for "The bond market's guess about future inflation", then aren't 'breakeven rates' (adjusted for liquidity premium, see below) better than the mere fact that some bonds are being purchased at expected negative real return?
As for negative real rates, seems to me those have been around for a while, especially in other countries. That's usually explained in terms of (a) low growth (b) safety premium, and (c) distortions from government-directed demand: public purchases, regulatory / capital requirements, and so forth.
Unadjusted breakeven inflation rates are definitely higher right now, 5 and 10 year at around the top of the range during the past 20 years. It's pretty volatile right now, but eyeballing it, it looks about 1% higher than the average for the five years prior to pandemic (PP is the new BC). That's not really that high in the scheme of things, but that indicates the market is pricing in above 2% inflation for years.
"If you thought that inflation was going to average much more than 2 percent over the next three years, you would never invest in securities yielding just 1 percent. Instead, for example, you could invest in Treasury inflation-indexed securities, which protect you against higher rates of inflation."
Some claim that the TIPS market is distorted by two premiums - one from scarcity (the Treasury doesn't sell 'enough' of them for all the people who want to hedge that way) and the other deriving from liquidity issues. I don't know if the combination of those factors could account for actual market expectations of inflation being significantly different from the apparent indicators of spreads / breakeven rates, so any finance professionals or whizzes please chime in!