Inflation Measures vs. Inflation Expectations
06/15/07
Last week began with high anxiety and nervous markets. Rising bond yields had caused falling stock prices, while the fear became more intense that inflation was going to rear its ugly head and derail this 4 year old bull market. Recessionary fears were also not entirely put to rest so that stagflation was uttered more than a few times in publications across the country. Monday’s trading was hesitant and Tuesday morning showed bonds gapping down (yields gapping up) in a panicky move that continued into the night session. Markets in Asia and Europe also showed skittishness the following day so that by Wednesday morning every trader in the universe was high strung and bracing himself for the economic data du jour. Retail sales were published first, coming in much stronger than expected, showing a rise of 1.4% in May, well above the 0.6% consensus estimate - bonds tanked immediately and yields shot up to 5.31% in a matter of seconds – and then the bids came in. Asian buyers and pension funds piled into the market and bought on the notion that 5.33% was enough compensation, even though the bond market can no longer discount a Fed easing because the Fed has no longer any reason to ease. On the contrary, the consumer sales data nudged Wall Street estimates of second-quarter GDP to above-trend levels. Economists at JPMorgan, Lehman Brothers and Bear Stearns all put 4% as a possibility for the second quarter. Stock market traders were worried about all this strong growth spurring inflation, but the Federal Reserve's inter-meeting report on economic conditions in the U.S., known as the beige book, came out at 2 p.m. EDT and put everyone at ease. Broadly, the beige book stated that economic activity continued to expand and that manufacturing activity was stronger but that "most Districts reported that overall wage pressures do not seem to have increased." So it happened that on the one day of the week which produced irrevocable proof of an accelerating economy that the bond market finally stabilized and buyers for stocks and bonds emerged. The ensuing rally started on Wednesday, did not stop until Friday afternoon and turned into the strongest 3 day advance since November 2004. The S&P 500 rose by 1.7% and the NASDAQ by 2% on the week.
The left picture above shows that the 10-T Note yield rose from 4.63% at the end of April to above 5.25% this week for the first time since summer last year although inflation as measured by the Core CPI has moderated to around 2.3% for the month of May. I extrapolated the CPI number to be able to show you this month’s yield advance in conjunction with the core CPI. The picture on the right shows the difference between nominal yields and inflation. That difference, the margin above inflation is called "Real Yield", and has been rising along with nominal yields. The most widely quoted reason was that Wall Street was gripped by "inflation fears". This characterization however is incorrect, since many other inflation measures show no sign of rising inflation or in fact have moderated recently. A falling gold price and a rising dollar would more likely indicate deflation than inflation. Falling CPI and core CPI numbers as well as the implicit price deflator have all reached their peaks in summer 2006 and confirm that this move in interest rates may indeed be for real, confirming the end of an era, but that it does not necessarily portend the beginning of runaway inflation. Let us look for the middle ground, here. It is one thing when bond yields rise because inflation is rising, it is another thing entirely when bond yields rise because they had been artificially depressed for so long. I think that the latter is what happened to fixed income markets around the world. Remember the "Zombie Buyers"? Those central banks in Asia that are intent on keeping their currencies stable against the dollar so that they can export to the US? They were known to be totally price and yield insensitive and they continued to buy even when 10-year T-Note yields traded as much as 0.75% below the Fed Funds rate. That seems to have changed. China evidently had enough of a good thing and openly discusses diversification into other areas, away from U.S. Treasury securities. This was reinforced last week with news that China was a net seller of Treasuries in April, its first net sale since October 2005. The prospect of continued central bank diversification is pressuring interest rates upward, and this should continue for a while. This week's benign CPI reading, therefore, provides only small solace for a bond market worried about more than just inflation. The Zombie Buyers are turning into rational earthlings.
The left picture above shows 10-year T-Notes at around 5.25% and 10-year TIPS (Treasury Inflation Protected Securities) The value of the TIPS are automatically adjusted to the inflation rate as measured by the Consumer Price Index (CPI). If the CPI goes up by half a percent the value of the bond would go up by half a percent. If the CPI falls, the value of the bond does not fall because the government guarantees that your original investment will stay the same. From the end of end of April through Friday, the 10-year TIPS yield rose 54 basis points, while 10-year note yield rose 52 basis points (a basis point is one-hundredth of a percentage point). That left the market's inflation forecast -- the nominal bond yield minus the inflation-indexed note yield, the so-called TIPS spread -- virtually unchanged. The essential reason for the back-up in bond yields was not the threat of inflation but the market's recognition that the Federal Reserve isn't about to lower its overnight federal-funds rate target from 5.25%, where it's been stuck for going on a year now. The parade of rate increases by central banks abroad underscores that global growth is strong and inflation pressures remain. Under those circumstances, the anomaly of sub-5% Treasury yields, the "Conundrum" as Greenspan called it, couldn't persist. The inversion of the yield curve has historically predicted recessions 6 – 12 months down the road. It has failed in its prediction this time! So now that the bond market is no longer supported by Zombie Buyers nor the fear of an imminent recession due to housing or sub-prime (or "who knows what else") induced consumer retrenchment, it is time for the yield curve to normalize. Short rates should be lower than long rates and this will be normal state of affairs for the rest of the year. This normalization process might produce one or two hiccups in the market, but I do not believe that the economy in this great land is in any danger to slip into a recession any time soon. The stock market has sniffed this out and continues its bull run. Wish you had bought the dip? It is not too late.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
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