What Is Going On In The Bond Market? Might We Expect Deflation?
Can we expect deflation?
If one looks at the US bond market, one could argue that some traders are certainly getting close to believing that the United States might be approaching a period of deflation.
The inflationary expectations that are built into the bond market have collapsed over the past two months, reflecting the effects of the spread of the coronavirus pandemic and the subsequent response of the Federal Reserve to mitigate the expected downward fall in economic activity.
But, one must be careful in interpreting the data because the US Treasury yields are still being impacted by the massive flow of risk-averse monies flowing into the ‘safe haven,’ the United States.
Let’s start out at the end of the last year. At that time, the yield on the 10-year US Treasury note was around 1.900 percent and the yield on the 10-year US Treasury Inflation Protected securities (TIPs) was around 0.125 percent.
Subtracting the 10-year TIPs yield from the yield of the 10-year note can provide us with an estimate of the inflationary expectations built into the 10-year nominal yield. Given the figures above, we come out with the inflationary expectations at that time being around 1.775 percent.
That is, traders were expecting that the compound rate of inflation for the next 10 years would be 1.775 percent per year.
It should be noted that the yield on the 10-year TIPs was being impacted by large amounts of money flowing into the United States from foreign countries. This flow had been going on for quite some time, as economic conditions in Europe and the rest of the world had become “shaky” and confidence had risen in the Federal Reserve and its chairman Jerome Powell.
One can support this view by looking at the strength of the US dollar in foreign-exchange markets. Concern had arisen last summer about Mr. Powell and the Federal Reserve System. It seemed as if the United States economy was still doing well while in other parts of the globe, other nations were experiencing some slowdown. The world was becoming disconnected.
There were worries that Mr. Powell and the Fed would not be up to the task of managing the situation. As a consequence, in late June, it took roughly $1.1400 to purchase one euro.
Early in July, Mr. Powell gave testimony in front of the US Congress that provided an initial burst of confidence in the Chairman, and this was followed up by Federal Reserve actions that confirmed Mr. Powell’s testimony. The value of the US dollar strengthened.
Money flowed into the US and by the end of July, one euro cost just under $1.1100. Money continued to flow into the US for the rest of the year and cost of the euro rose slightly.
Treasury Yields Since January 1, 2020
Treasury yields dropped precipitously right after the first of the year. The interesting thing is that the inflationary expectations built into the yield on the 10-year Treasury note remained near 1.70 percent through February. But, other things changed.
The yield on the 10-year TIPs fell through the floor. Where the yield on the 10-year TIPs was around 0.125 percent at the end of 2019, by the end of January they had dropped into negative territory.
Something was going on. Nothing had changed at the Fed yet, and, at least in the United States, the fear connected with the coronavirus pandemic had not raised its head. But, by the end of January, the yield on the 10-year TIPs was around –0.100.
This raises, to me, a question about information concerning the pandemic being more generally available outside the United States than it was inside the United States. Starting in January, the flow of international monies into the United States rose dramatically.
Through the month of January, the value of the dollar got stronger and early in February one could buy one euro for less than $1.0900.
Federal Reserve Responds
With the growing news of the spreading pandemic and fears about what the spread might do to the US economy, the Federal Reserve acted, and acted strongly in the third and fourth weeks in February. In dating the time when Federal Reserve’s actions really began to impact the Fed’s balance, I start my measure as February 26, 2020, the end of a banking week as defined by the Federal Reserve. The Fed moved to put a floor under financial markets to protect the banking and financial system, both in the United States and in the world.
Early in March, the yield on the 10-year TIPs was –0.325 percent, and the inflationary expectations built into the yield on the 10-year US Treasury note approached 1.00 percent.
Furthermore, the situation in the oil industry became catastrophic in March and April with oil prices falling dramatically even moving into negative territory around April 20.
Three points here. First, “safe haven” monies continued to flow into the US helping to lower the yield on the 10-year TIPs; second, the Federal Reserve was injecting lots and lots of liquidity into world markets and this, I believe, also contributed to the decline in the TIPs yield; and third, traders began to build into bond yields on reality that the United States and the world were going to experience a pretty severe economic downturn, possibly connected with negative inflation connected with the crisis in the oil industry.
On Thursday, April 23, the yield on the 10-year TIPs has fallen below to –0.455 percent and inflationary expectations are just above 1.00 percent.
The US dollar has remained strong. On Thursday, April 23, it took only $1.0775 to purchase one euro. Money continues to flow into the US as the Federal Reserve continues to pump liquidity into the banking system and financial markets.
Could the economic downturn be severe enough that we might experience deflation over the next few years as growth drops into negative territory for a longer time than many expect and the oil price remains at very low levels. The inflationary expectations built into the 5-year US Treasury note is about 0.70 percent, so we could have a couple of years of falling prices.
The alternative is that world economies, including the US, begin to experience a sharp turnaround in the fall. As we read in the Financial Times, we could get a “V” recovery where the Federal Reserve would have to “scoop up” an enormous amount of the government debt created to protect the US economy. In this case, the Financial Times argues, the value of the dollar would drop quite a bit.
This leaves me with the same advice that I have given out a lot over the past several years. Watch the value of the US dollar when watching other variables, like the yields on US Treasury securities.
The United States works in a world market now and what happens in the US markets, like the US bond market, depends upon not only things happening in the US but also on things happening around the globe. In the current situation, US bond yields reflect the fact that the US remains a “safe haven” for risk-averse monies from around the world. And, the strength of the US dollar confirms that traders and investors “trust” the Federal Reserve system in protecting their funds. And, this is true even though we are now going through a severe economic decline, one that seemingly could be connected with deflation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.