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Fed policy restarts the reflation trade




The FOMC's announcement today didn't reveal any signs of panic on the part of the Fed, but it did further open the door to another round of quantitative easing (aka QE2): "... the committee is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." The market rationally interpreted this to be yet another sign that the Fed would rather err on the side of more inflation rather than less (or deflation). Predictably, measures of inflation expectations rose across the board. Gold has risen some $37/oz. so far this month, reaching yet another all-time high today. Gold is up against almost all currencies this month, but more so against the dollar, since it has fallen about 1.2% against a basket of major currencies.


TIPS are a reliable, if conservative, hedge against inflation, and TIPS yields/prices reached a new all-time low/high today. This is a direct reflection of investors' demands for inflation hedges, just as are record-high gold prices. Real yields on 10-yr TIPS have fallen 20 bps so far this month, while yields on 10-yr Treasuries are up 10 bps on the month; this translates into a 30 bps increase in average annual CPI expectations over the next 10 years. A more sensitive measure of inflation expectations, which is preferred by the Fed, is the 5-yr, 5-yr forward breakeven inflation rate; it has risen by over 50 bps so far this month, to a current 2.54%.



Other sectors of the bond market also reveal a recent increase in inflation expectations. As the chart above shows, the spread between 10- and 30-yr Treasury bond yields is now about as high as it has ever been (on a daily basis, we saw a record-high spread of 124 bps in early August). By insisting that short-term rates will remain low for a long time come what may, the Fed has helped 10-yr yields fall. But investors in 30-yr bonds have little or no reason to worry about what the funds rate will average over the next 10 years (a factor that does weigh heavily on the decision whether or not to buy the 10-yr), and they have decided that inflation risk outweighs carry concerns; as a result, 30-yr yields are up 25 bps on the month while 10-yr yields are up only 10 bps.

So we have now reached the point where the Fed's actions and its talk are definitely boosting reflationary expectations. By the same token, deflationary fears are declining. Monetary policy is "gaining traction," as economists are wont to say. Much as I hate the thought of higher inflation, I am not surprised to see equity prices up almost 9% so far this month. Reflation is good news for the equity market (and for high yield bonds) because a) it perforce reduces deflation risk, and b) it increases expected future cash flows without (so far) causing any significant rise in long-term interest rates.

My sense is that with the economy still on the mend—albeit slowly (i.e., modest growth of 3-4%, enough to bring down the unemployment rate in a very slow and painful fashion), and reflationary monetary policy gaining traction, we are now seeing a virtuous cycle kicking in that will at the very least act to help the economy grow. Consumers and businesses that have been hoarding massive amounts of money (as reflected in 12% decline in the velocity of M2 since the end of 2007) are now feeling increased pressures to unhoard some of that money, releasing it to be spent in a fashion that boosts nominal and real GDP. In the latter stages of this reflation process we would likely see an obvious buildup of inflation pressures, but for now this is of secondary concern.

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