Bond Market Smells Inflation, Begins to React


by Wolf Richter, Wolf Street:

Inflation expectations now exceed the Fed’s target.

The 10-year US Treasury yield breached 2.5% on January 9 and hasn’t looked back since, closing on Friday at 2.55%. The three year yield closed at 2.12%, the highest since October 2008. The two year yield, after breaching 2% on Friday intraday, closed at 1.99%, the highest since September 2008.

Bond prices fall when yields rise. And the selloff in three-year maturities and below shows that the short end of the bond market is reacting to the Fed’s rate-hike environment.

The moves in the 10-year yield, however, defied the Fed in much of 2017, with the yield actually dropping. With long-term yields falling and short-term yields rising, the yield curve “flattened,” and there were fears that the yield curve would “invert,” with 10-year yields dropping below two-year yields – a scenario that has proven dreadful in the past, including just before the Financial Crisis. But recently, the 10-year yield too has begun to respond.

Though the “new Fed” in 2018 hasn’t fully taken shape yet, with several key vacancies still to be filled, there is already tough talk even among the “doves.” And that’s where tough talk matters.

On Thursday it was New York Fed President William Dudley who outlined the “two macroeconomic concerns” he is “worried about”: “The risk of economic overheating,” and that the markets are blowing off the Fed. In the end, the Fed “may have to press harder on the brakes,” he said.

On Friday, it was Boston Fed President Eric Rosengren who told the Wall Street Journal that he expected “more than three” rate hikes this year to get this under control before it’s too late. “I don’t want to get to a situation where we have to tighten more quickly,” he said, citing specifically the “fairly ebullient financial markets,” and the risks of waiting too long.

These “doves” are worried that the Fed will have to speed up its rate hikes to get a grip on asset price inflation, wage inflation, and consumer price inflation before they become difficult to control.

Labor markets have become “tight.” Consumer prices as measured by annual CPI rose 2.1% in December. This means that Treasury securities with maturities of less than three years are still losing their purchasing power faster than they’re compensating investors for it with higher yields. This is considered very stimulative.

In June, the trough of last year’s “low inflation” dip, CPI rose by 1.6%. Wall Street and its economists were clamoring for no more rate hikes. But Fed Chair Janet Yellen shrugged them off, saying that there were some special effects that caused this dip in inflation, but that it would be “transitory.” By early October, the underlying data showed that Yellen had been right.

Even while Wall Street’s economists continued to clamor for a slow-down of the already glacially slow rate hikes, the Treasury bond market was starting to read the memo. And recently, its inflation expectations have spiked.

The Treasury market’s inflation expectations can be seen in the premium that investors demand for holding 10-year Treasuries over Treasury Inflation Protected Securities. The principal of these TIPS increases at the rate of annual CPI. Thus the principal is protected from inflation. Holders also receive a small yield. The difference between the TIPS yield and the 10-year yield – the premium investors demand – is the bond market’s expectation of where inflation is headed over the next ten years. That expectation breached 2% on January 4 for first time since last March. It ended Friday at 2.01%. Note how it has recently been spiking:

Importantly, this expectation of 2.01% inflation now exceeds the Fed’s annual inflation target.

How did this happen? In recent weeks, investors, increasingly worried about inflation, bought TIPS. Prices of TIPS rose and their yields fell. At the same time, these worried investors sold off their regular Treasuries. Prices fell and yields rose. This is a time-honored strategy by conservative investors when facing an environment of rising inflation.

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