Thursday, November 30, 2006

Is the U.S. Bond Market On Dope?

Now, I've never been an advocate of the so-called "efficient market hypothesis" and have in fact argued against it. But I am still amazed at how irrationally low the inflation expectations of the U.S bond market is. Although the current year over year inflation is relatively low and one of the primary arguments for a short-term increase in inflation -the previously assumed surge in unit labor costs- was revised away yesterday, there is still good reasons to believe that inflation will accelerate in the short-term despite the economic slowdown. And there is no reason to believe Ben "Helicopter" Bernanke will be less inflationary than Greenspan över the coming years. Some people must have confused "Black Hawk" with inflation hawk. And during Greenspan, the average inflation rate was 3%. So, how could there be a mere 2.30% spread between the regular 10-year note and the 10-year TIPS?

While no one can know the future for sure, and so it is possible that inflation will be 2.3% or lower per year during the coming decade . But that would require that Bernanke would pursue a significantly less inflationary policy than Greenspan, which seems highly unlikely. With the massive debt overhang of the U.S. economy, it seems in fact a lot more likely that the Fed will try to inflate more to bail out the heavily indebted households.

With the real yield being a mere 2.21%, I wouldn't recommend anyone to buy the TIPS. But it is certainly a lot better deal than the regular government securities.


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