Bond Market Has Been Clueless about Inflation for Decades, Now More so Than Ever. The Meme the Drop in Yields = End of Inflation is a Fantasy


by Wolf Richter, Wolf Street:

Even before QE, the 10-year yield lagged years behind CPI, up and down. And now, the Fed manipulates the market with QE.

The 10-year Treasury yield was 1.75% at the end of March, but by July 19, it had dropped to 1.19%, and on Friday it closed at 1.30%. This drop in the yield occurred even as inflation spiked. On a month-to-month basis for the past three months, and annualized, the Consumer Price Index spiked by 9.5%, the red-hottest since 1982. Year-over-year, CPI in June jumped 5.4%.


But the new meme now is that the drop in the 10-year Treasury yield is telling us the spike in inflation is nothing to worry about, and that by next early year, CPI will be at 1% or 1.5% or whatever. The meme now is that the bond market is right and CPI is wrong or something.

Historically, for much of the time, the 10-year yield is higher than the rate of annual CPI, meaning the “real” 10-year yield (after inflation) is positive. But there are periods when the 10-year “yield” is below CPI, for a negative real yield. Currently, with the 10-year yield at 1.3% (black line) and annual CPI at 5.4% (red line), the 10-year “real” yield is -4.1%, the most negative since June 1980:

The Fed controls the short end of the Treasury market through its policy interest rates, and it manipulates the long-term bond markets with its bond purchases. QE is designed to push down long-term interest rates, and there has been $4 trillion in QE over the past 16 months in the US alone, and it has been pushing down interest rates just fine.

The Fed is currently buying a lot more than $120 billion a month; it is adding $120 billion a month to its pile, but it’s buying a lot more to do so.

It’s buying $80 billion in Treasury securities and $40 billion in MBS to add to its pile, plus it is also buying Treasury securities and MBS to replace those that have matured and come off its balance sheet, plus it’s buying MBS to replace pass-through principal payments of the MBS it is holding. Therefore, the monthly intervention in the bond market is closer to $200 billion than $120 billion.

When a homeowner refinances a mortgage, the original mortgage gets paid off, and that payoff amount is passed through to the holders of the MBS. The current refi boom has turned pass-through principal payments into a tsunami. The Fed has to replace these pass-through principal payments with MBS purchases. These replacements run at close to $60 billion a month.

For example, in the two-week period between July 12 and July 23, the New York Fed purchased a total of $51 billion in MBS. This makes for a monthly run-rate of over $100 billion, with $60 billion replacing maturing MBS and pass-through principal payments, and with $40 billion making the pile grow.

This is why the Fed’s interventions in the bond market (Treasury and MBS) are closer to $200 billion a month than just the $120 billion a month.

In addition, the Fed doesn’t trade. It just buys. This $200 billion a month is a one-way demand. And it pushes up the prices of those bonds, and it pushes down their yields.

In addition, other central banks, such as the ECB and the Bank of Japan, have repressed interest rates into the negative, and so there are also some spill-over effects into the US bond market.

In addition, the trillions in liquidity created by global QE since March 2020 is chasing assets and yield, and this has led to the craziest phenomena, in terms of pushing down yields, such as BB-rated US junk bond yields dropping to 3.15% currently, producing a negative real yield for junk bonds even!

None of this is a reflection of inflation going negative, but of central bank manipulations. The bond markets are reacting exactly as central banks are working so hard to get them to react. Bond markets are the most manipulated markets in the universe, manipulated by unlimited central bank money-printing. And these markets are silent about inflation. They don’t care. They only care about the Fed.

So this notion that there is a bond market that is allowed to react to surging inflation is rather quaint and outdated. The Fed and other central banks that inflict QE on their realm are making sure that the bond market does not react to inflation.

But even before QE, bond markets got inflation wrong, in both directions.

Below is a chart of CPI (red) and the 10-year Treasury yield (black). Back in the early 1970s, CPI surged due to the oil shock, part of which unwound, but not all; it bottomed out at 5% in 1976 and then spiraled higher and deeper into the economy. Throughout that time as CPI was spiking, the 10-year yield predicted nothing. It was lagging behind, leisurely trying to not fall further behind CPI.

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