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The return of the bond market vigilantes

This chart highlights two very interesting developments. I'll begin with the 40 bps rise in 10-yr Treasury yields that has occurred over the past month. 10-yr yields are now about 33 bps higher than they were just prior to Bernanke's late-August unveiling of plans for QE2. What is interesting is that even though the FOMC has now confirmed it will be buying/monetizing up to $600 billion of Treasury bonds of up to 10 years' maturity over the next 8 months, the bond market has decided to stage a protest. That protest has sent 10-yr yields up by 33 bps, and 30-yr yields up by a whopping 80 bps in just a few months.

The Fed can exercise some influence over (a euphemism for manipulate) Treasury yields out to 10 years, but only if it can convince markets that it is embarking on a credible policy to target the overnight Fed funds rate in a particular manner. For some time now, that has consisted in repeated assertions that, because of the large amount of slack or idle resources in the economy, the Fed will keep overnight rates close to zero for a very long time. If the market agrees that the funds rate is likely to be close to zero for a few more years, then investors bid up the price of all Treasuries (and lower their yields correspondingly). The market does this until investors become indifferent between investing at the overnight rate or investing in 2, 5, 7, or 10-yr Treasuries—because they figure they will earn the same amount of interest over time either way. But the Fed has almost no control over 30-yr Treasury yields, since those are determined almost entirely by market forces, which in turn are driven by expectations of future economic growth, future inflation, and future Fed policy actions. (And because 30 years is just way too long for anyone to be able to extrapolate the future course of of all these variables with any degree of confidence.)

So the big rise in 30-yr yields that I have been highlighting for the past few months was the first clue that the market was starting to get uncomfortable with the idea of QE2. Too much money printing would surely cause inflation to rise in the future, and rising inflation would surely (eventually) cause the Fed to raise overnight rates. So why buy bonds that were paying historically low yields with the expectation that the funds rate could be zero for a very long time? The rise in 30-yr yields is a good sign that the fabled "bond market vigilantes" are mobilizing once again. The bond market is not going to be sweet-talked into accepting historically low yields at a time when the Fed is talking about throwing money out of helicopters in order to push the rate of inflation higher.

The next very interesting development shown in the chart above is the relatively tight correlation between bond yields and core inflation over the past several years. In an efficient market there should be a fairly close and predictable relationship between risk-free yields and the underlying rate of inflation in an economy. That's because investors and market participants have the ability to arbitrage between financial markets and physical markets. For example, if prices of most things are rising 10% a year, it wouldn't make sense to buy a risk-free bond that pays only 2% interest—much better to sell low-yielding bonds and buy real estate, gold, and/or commodities. Similarly, in an environment of nearly zero inflation, investors would not long ignore the opportunity cost of not owning risk-free bonds paying 10% interest—intense demand would drive bond yields down to a level more consistent with underlying inflation. Over long periods, it is generally the case that risk-free bond yields are largely determined by inflation.

(Note that the two vertical axes of the chart are offset by 2 percentage points. When the two lines sit on top of each other, that is an indication that Treasury yields are 2 percentage points higher than inflation. This is a way of showing that real 10-yr interest rates—the difference between nominal yields and inflation—tend to be 2% on average over time.)

I say that the chart above is interesting not because it illustrates the well-known relationship between interest rates and inflation, but because it provides evidence that the main reason 10-yr Treasury yields have been so low is that inflation has been low. It's been surprising to me that inflation has remained so low, given that Fed policy has been ultra-accommodative for the past two years, the dollar has been historically weak, and gold and commodity prices have been soaring.

In my defense I could argue, as some do, that inflation has been badly calculated and in reality is much higher than reported. But in my long experience with government statistics I have never uncovered evidence which undermines the credibility of U.S. government inflation calculations (the same can't be said of Argentina, however). So I prefer to think I have been the victim of Milton Friedman's assertion that "the lags between monetary policy and the economy are long and variable." Inflation has fallen more, and for longer, than I have been expecting. But that doesn't necessarily mean I'm wrong, or that interest rates and inflation won't be higher in the future. It could just mean that the lags have been unusually long this time, perhaps due to the nature of the recent recession.

In any event, there is a valid monetary explanation for why inflation has been very low, and it goes back to the events of 2008. The financial crisis was such a shock to consumers and investors all over the world that the world's demand for dollars soared almost beyond comprehension. It took the Fed awhile to recognize this, and to counteract the huge shift in money demand with a correspondingly large shift in money supply. This introduced some serious deflationary pressure into the mix, and that showed up in TIPS breakeven inflation rates that were very low and even negative by the end of 2008. A deflationary shortage of dollars also showed up in a huge spike in the dollar's value towards the end of 2008, and a significant decline in the price of gold and commodities from mid-March through late 2008.

The recent rise in 10- and 30-yr Treasury yields is likely telling us that inflation is finally set to rise. It wouldn't be surprising at all, given how accommodative monetary policy has been and promises to be. There is no shortage of evidence that money is in abundant supply: gold and commodity prices are soaring, the dollar is scraping the bottom of the barrel, and forward-looking inflation expectations built into TIPS prices have risen from 2% to almost 3% in the past several months. If inflation is indeed about to turn up, then no amount of QE2 can keep Treasury note and bond yields from rising. Actual and expected inflation can easily overpower even the most determined efforts of the Fed to keep long-term interest rates artificially low. The Fed is no match for the bond market vigilantes once they are aroused; the $9.1 trillion of Treasury debt outstanding is an order of magnitude larger than the Fed's proposed QE2 purchases.

I sense that the stock market has been getting nervous of late over these same issues. Bond yields are rising, yet the Fed is already in the process of buying bonds. What's going on? Is the Fed on the wrong track? Is the Fed going to wimp out on its QE2 promises? Could deflation return? Could the economy suffer a setback? Lots of uncertainty, and uncertainty is never good for stock prices.

It's often said that the market has a way of surprising the greatest number of people at the most unexpected of times. If that's to be the case once again, then we could be on the cusp of some very surprising developments. The current consensus is so firmly entrenched in the view that the economy is going to be struggling (i.e., the "new normal") for a long time and that inflation is absolutely dead, it would be a real shock if the economy and inflation were instead picking up. The shifting political winds in Washington are already blowing in a more positive "growth" direction, after all.

I'm not afraid of rising Treasury yields, since they would be effectively signaling a healthier economy, the death of deflation fears, and the beginnings of some inflationary relief for underwater homeowners. Before too long, we would probably see the Fed put QE2 on hold, then decide to start raising the funds rate; that would cause all short-term rates to rise, and that in turn would be a very welcome relief to all those who are holding CDs and money market funds. Borrowing costs for individuals and businesses shouldn't have to rise by much, since credit spreads are still much wider than they tend to be during times of healthy economic growth. Rising Treasury yields would be painful for the Federal government, but a stronger economy and new efforts to control federal spending should cause a significant narrowing of the deficit over the next few years.

I'm hoping the rise in inflation won't get out of hand, since that would bring a whole host of problems (e.g., a major Fed tightening followed by another recession). But lots of water has to pass under the bridge before we will need to worry about inflation getting too high.

Commodity prices point to ongoing recovery and rising inflation

Crude oil is now trading at a post-recession high of $88/bbl (first chart). Many non-energy industrial commodities (second chart) are now trading at all-time-high prices. With few exceptions, almost all commodity prices are rising: soybean prices, for example, have jumped 50% since last June. This is not the stuff of double-dip recessions, nor is there even a hint of deflation in these facts. The only legitimate question is whether the rise in commodity prices is being driven by accommodative monetary policy (i.e., too much money) or strong growth in global demand (i.e., the forces of recovery), or by some combination of the two.

I've been arguing for awhile—since early last year—that rising commodities are an excellent portent of recovery. We've seen lots of confirmation of recovery since then: strong growth in corporate profits, rising equity prices, rising federal revenues, rising auto sales, rising incomes, rising jobs, rebounding global trade, and declining swap and credit spreads, to name just a few.

I've also argued repeatedly that higher commodity prices are symptomatic of accommodative/inflationary monetary policy.

This next chart shows that the dollar has been highly inversely correlated with commodity prices since mid-2001 (-0.85). Not coincidentally, 2001 was the year in which the Fed started to ease after tightening so much in the late 1990s that the dollar soared and commodities collapsed in the early 2000s. Gold began rising in early 2001, at about the time the Fed first started easing, and commodities started rising by late 2001. The Fed kept interest rates exceptionally low from mid-2002 through mid-2004, during which time the dollar fell sharply and commodities rebounded strongly. I think this all makes the point that the Fed's monetary policy stance has played a strong role in the evolution of commodity prices for many years now, and that therefore the latest rise in commodity prices is due at least in part to easy money and thus a portent of rising inflation.

The rise in commodity prices which began early last year has not been nearly as well correlated to the dollar (-0.36) as it was in the mid-2001 to late 2008 era (-0.87), which in turn suggests that there have been other factors at work since early last year that have been more dominant, namely the forces of recovery.

Irrefutable sign of recovery: federal receipts up

Since its low-water mark last January, the rolling 12-month total of federal government revenues has been rising at an annualized rate of 10%. In the past six months, the rolling 12-month total of federal government receipts has risen at a 12.5% annual pace. This has nothing to do with tax rates, since they haven't changed at all. It is entirely attributable to rising incomes and profits, and those in turn provide irrefutable evidence that the economy is improving. In a similar vein, Mark Perry in a series of posts has noted the long and growing list of states that are registering strong growth in receipts, the latest of which is here.

Just as declining revenues are a hallmark of recessions, rising receipts are a hallmark of recoveries.

I note with great relief that the 12-month rolling total of federal spending has been flat since June '09. The narrowing gap between spending (flat) and revenues (rising) has brought the 12-month federal deficit down from a peak of $1.48 trillion last February, to $1.26 trillion in October. In terms of GDP, the deficit has declined from a high of 10.3% last December, to approximately 8.5% in October. This is welcome progress, of course, but to bring the deficit down to a more reasonable level (say, 3-4% of GDP) in coming years we need to avoid the huge spending ramp-up that will occur if ObamaCare is fully implemented and entitlement programs are not trimmed.

I am encouraged that the Republican victory in last week's elections came with a clear mandate to curb the growth of government and keep taxes from rising. The political winds have shifted to a degree that should find at least a majority of Senators, and perhaps 60 or more, who are willing to extend the Bush tax cuts for all taxpayers for at least the next two years. Already the Republicans' coming control of the House should be enough to put a break on the growth of spending, which could result in at least an important de-funding of the spending necessary to implement ObamaCare.

The early recommendations of the Bowles-Simpson deficit commission, released yesterday, are highly encouraging. If at least some of the ideas gain currency, we could see significant and very positive reforms. Eliminating deductions in order to get lower and flatter tax rates for individuals and corporations is a very positive change. Reining in the growth of entitlements, defense, and discretionary spending is essential, and it is a key part of the Republicans' mandate and key objectives. Those reforms would almost certainly boost the prospects for future growth, and reinforce the healthier trends in spending and revenues that we have seen so far this year. There is plenty of light at the end of the deficit tunnel, and continued recovery seems all but assured.

Continued slow progress in the labor market

The 4-week moving average of weekly unemployment claims has dipped to a new post-recession low, and the weekly number has surprised the market for the past few weeks by coming in a bit below expectations. What's driving this is not an actual decline in claims, but the fact that claims (which normally are increasing at this time of the year) are not increasing. Still, this is good news since it implies that companies on average are a bit leaner and meaner than they have been for some time, and have less reason to lay people off. Relative to the total number of employed (second chart), unemployment claims are showing a modest improvement on the margin. No sign of a double-dip, but no signs either of strong growth.

Meanwhile, the number of people receiving unemployment benefits continues to decline, albeit slowly.

The market gives a big thumbs-down to QE2

There is a rising, worldwide tide of protest against the Fed's decision to proceed with QE2. Today's WSJ has an excellent op-ed on the subject, which included an insightful quote from Sarah Palin: "We don't want temporary, artificial economic growth brought at the expense of permanently higher inflation which will erode the value of our incomes and our savings." That captures the essence of the layman's QE2 concerns.

The chart above shows that the bond market is protesting as well. 30-yr bonds—which are quite beyond the scope of the Fed's planned bond purchases, and generally immune to Fed manipulation in any event—have been marching steadily higher in yield (and lower in price) ever since late August, when the Fed began pre-announcing its intention to proceed with QE2. Quite simply, the bond market is telling us that QE2 will indeed accomplish its stated objective of increasing inflation. Gold, trading today at over $1400/oz., is also telling us that QE2 will prove inflationary. Industrial commodity prices are at all-times high as well, and the dollar is at or near all-time lows against other currencies.

The issue now becomes this: how long will the Fed ignore the growing number of market signals that its proposed QE2 is not a good idea? Dissension among the Fed governors is growing, and I note Kevin Warsh's op-ed in the WSJ the other day as being particularly well thought out. Encouragingly, he makes it clear that the only rational way to stimulate the economy is through the supply-side, not with monetary policy:

The U.S. and world economies urgently need stronger growth, and the adoption of pro-growth economic policies would strengthen incentives to invest in capital and labor over the horizon, paving the way for robust job-creation and higher living standards.
Pro-growth policies include reform of the tax code to make it simpler, more transparent and more conducive to long-term investment. These policies also include real regulatory reform so that firms—financial and otherwise—know the rules, and then succeed or fail. 
I think Bernanke must be a very nervous man these days. He is determined not to let deflation show up on his watch. But I doubt whether he is going to plunge ahead with QE2 in the face of mounting opposition to inflationary policies, and mounting evidence that deflation and a liquidity shortage are the least of the economy's problems at this juncture. I think that when push comes to shove we are going to see that QE2 is a conditional policy objective, not cast in stone. It can and most likely will be shut down or put on hold before too long.

Diesel trucking activity has slumped

The UCLA/Ceridien Pulse of Commerce Index has registered a 3-mo. slump through October. While this confirms other signs of a pause in the economy's recovery process (they called it a "recovery time out"), it doesn't correlate with other signs of continued growth (e.g., rising industrial metals prices, strong corporate profits, growth in air travel, growth in money supply). Regardless, this is one of the few signs I've seen that would suggest another quarter of weak GDP growth. My sense is that the index is wrong this time, but it is a cautionary note that bears watching.