Jim Nickerson
01-14-08, 11:26 PM
http://www.marketwatch.com/news/story/contrarian-take-inflation-risks/story.aspx?guid=%7BB92D788C%2D09AE%2D46DC%2DBA10%2 DF3BBE3AF23AD%7D
1/14/08 Commentary: The bond market is not betting that inflation will get worse
ANNANDALE, Va. (MarketWatch) -- Inflation has heated up considerably in recent months, and is about to get even worse.
That opinion is so widely held these days that it is with some trepidation that I subject it to scrutiny. After all, isn't it obvious that the Federal Reserve has been prevented from lowering interest rates any faster than it already has by fears of stoking the already-hot inflationary fires?
And isn't it obvious that this is why gold bullion (38099902 (http://www.marketwatch.com/quotes//38099902): News (http://www.marketwatch.com/tools/quotes/news.asp?symb=38099902), chart (http://www.marketwatch.com/tools/quotes/intchart.asp?symb=38099902),
has recent broken out to a new all-time high?
But questioning widely held opinions is the lonely fate of contrarian analysts.
Humphrey Neill, the Vermonter who published the Neill Letters of Contrary Opinion in the middle part of the last century and who is widely considered the father of contrarian analysis, insisted that widely held opinions are often wrong precisely because people stop subjecting them to critical scrutiny.
So here goes.
For starters, consider the judgment of the bond market about inflation. Believe it or not, that market does not believe inflation to be any bigger a threat today than it was a year or two ago. If anything, it considers that threat to be slightly lessened.
I can say this with such precision because of the appearance a decade ago of inflation-protected Treasury securities, or TIPS. Their existence makes it possible to quantify the collective judgment of bond traders about the magnitude of inflation over the next several years.
Contrast the nominal yield on the 10-year Treasury note, which currently stands at 3.82%, with the yield on the 10-year TIPS, which currently is 1.56%. The difference between those two yields -- 2.26% -- is the bond market's collective judgment of inflation's average rate over the next 10 years.
If bond traders collectively believed inflation to be greater than this, they would sell the nominal 10-year note (thereby pushing its yield higher) and buy the 10-year TIPS (thereby causing its yield to fall) until the spread between the two yields had widened sufficiently.
But they haven't done that.
One year ago, in fact, this spread between the nominal and inflation-protected 10-year Treasury note stood at 2.28%, essentially the same as where it stands today. Two years ago the spread stood at 2.39%, 13 basis points higher than where it is now.
How might investors take issue with this analysis? One objection I can imagine that some will make is that the inflation against which TIPS are protected -- the Consumer Price Index -- is a flawed measure of true inflation. But I have a hard time giving much credence to this argument.
Sure, the CPI is a flawed barometer. But for this objection to hold water, it would have to be the case that none of the increase in genuine inflation's expected rate will translate into higher consumer prices over the next 10 years. Though the CPI in a given month or quarter might stay put despite higher genuine inflation, it is difficult to imagine that a huge increase in genuine inflation wouldn't bleed over into higher consumer prices at some point in the next decade.
Another objection might be that the nominal 10-year note has been artificially brought down by a flight to quality caused by nervous stock investors who have liquidated their equities and bought bonds. But, once again, I have a hard time giving much weight to this objection.
After all, why should a flight to quality only result in the purchase of nominal Treasuries and not TIPS? Shouldn't both kinds of Treasuries benefit proportionally from a flight out of equities, leaving the spread between their yields more or less the same?
Consider where the spread between the nominal and inflation-protected Treasuries stood this past October when the Dow Jones Industrial Average $INDU (http://www.marketwatch.com/tools/quotes/quotes.asp?symb=$INDU) 12,778.15, +171.85, +1.4%) reached its all-time high. It stood then at 2.34%, just eight basis points higher than where it stands today. So the flight to quality that has undoubtedly occurred over the past three months can't explain why the bond market's inflationary expectations are so low.
Is this analysis the final word on the subject? Of course not. Nothing ever is.
But I should think that the bond market's judgment should give pause to those who are sure that inflation is heating up. After all, the many-trillion-dollar bond market is perhaps the largest financial market in the world, even larger than the market for equities, and many times larger than the market for gold.
How sure are you that the bond market is wrong?
This is a rather provocative article from which I take it the bond market is saying inflation ain't no big deal. So if inflation is not a big deal, then is deflation going to be a big deal?
1/14/08 Commentary: The bond market is not betting that inflation will get worse
ANNANDALE, Va. (MarketWatch) -- Inflation has heated up considerably in recent months, and is about to get even worse.
That opinion is so widely held these days that it is with some trepidation that I subject it to scrutiny. After all, isn't it obvious that the Federal Reserve has been prevented from lowering interest rates any faster than it already has by fears of stoking the already-hot inflationary fires?
And isn't it obvious that this is why gold bullion (38099902 (http://www.marketwatch.com/quotes//38099902): News (http://www.marketwatch.com/tools/quotes/news.asp?symb=38099902), chart (http://www.marketwatch.com/tools/quotes/intchart.asp?symb=38099902),
has recent broken out to a new all-time high?
But questioning widely held opinions is the lonely fate of contrarian analysts.
Humphrey Neill, the Vermonter who published the Neill Letters of Contrary Opinion in the middle part of the last century and who is widely considered the father of contrarian analysis, insisted that widely held opinions are often wrong precisely because people stop subjecting them to critical scrutiny.
So here goes.
For starters, consider the judgment of the bond market about inflation. Believe it or not, that market does not believe inflation to be any bigger a threat today than it was a year or two ago. If anything, it considers that threat to be slightly lessened.
I can say this with such precision because of the appearance a decade ago of inflation-protected Treasury securities, or TIPS. Their existence makes it possible to quantify the collective judgment of bond traders about the magnitude of inflation over the next several years.
Contrast the nominal yield on the 10-year Treasury note, which currently stands at 3.82%, with the yield on the 10-year TIPS, which currently is 1.56%. The difference between those two yields -- 2.26% -- is the bond market's collective judgment of inflation's average rate over the next 10 years.
If bond traders collectively believed inflation to be greater than this, they would sell the nominal 10-year note (thereby pushing its yield higher) and buy the 10-year TIPS (thereby causing its yield to fall) until the spread between the two yields had widened sufficiently.
But they haven't done that.
One year ago, in fact, this spread between the nominal and inflation-protected 10-year Treasury note stood at 2.28%, essentially the same as where it stands today. Two years ago the spread stood at 2.39%, 13 basis points higher than where it is now.
How might investors take issue with this analysis? One objection I can imagine that some will make is that the inflation against which TIPS are protected -- the Consumer Price Index -- is a flawed measure of true inflation. But I have a hard time giving much credence to this argument.
Sure, the CPI is a flawed barometer. But for this objection to hold water, it would have to be the case that none of the increase in genuine inflation's expected rate will translate into higher consumer prices over the next 10 years. Though the CPI in a given month or quarter might stay put despite higher genuine inflation, it is difficult to imagine that a huge increase in genuine inflation wouldn't bleed over into higher consumer prices at some point in the next decade.
Another objection might be that the nominal 10-year note has been artificially brought down by a flight to quality caused by nervous stock investors who have liquidated their equities and bought bonds. But, once again, I have a hard time giving much weight to this objection.
After all, why should a flight to quality only result in the purchase of nominal Treasuries and not TIPS? Shouldn't both kinds of Treasuries benefit proportionally from a flight out of equities, leaving the spread between their yields more or less the same?
Consider where the spread between the nominal and inflation-protected Treasuries stood this past October when the Dow Jones Industrial Average $INDU (http://www.marketwatch.com/tools/quotes/quotes.asp?symb=$INDU) 12,778.15, +171.85, +1.4%) reached its all-time high. It stood then at 2.34%, just eight basis points higher than where it stands today. So the flight to quality that has undoubtedly occurred over the past three months can't explain why the bond market's inflationary expectations are so low.
Is this analysis the final word on the subject? Of course not. Nothing ever is.
But I should think that the bond market's judgment should give pause to those who are sure that inflation is heating up. After all, the many-trillion-dollar bond market is perhaps the largest financial market in the world, even larger than the market for equities, and many times larger than the market for gold.
How sure are you that the bond market is wrong?
This is a rather provocative article from which I take it the bond market is saying inflation ain't no big deal. So if inflation is not a big deal, then is deflation going to be a big deal?