Thursday, March 19, 2009

Treasury Yields & Inflation Issue Revisited

Yves Smith at the Naked Capitalism blog writes this regarding the market effects of the "Shock and Awe" inflationary shock from the Fed yesterday:

"As readers no doubt know, stocks took off, bonds rallied big, as did gold (note the last two are contradictory)"

Smith doesn't elaborate upon why she thinks it is contradictory with a rally in bonds and a rally in gold, but presumably this assertion is based on a belief that a rally in bonds indicates falling inflationary expectations, while a rally in gold indicates rising inflationary expectations. This illustrates the confusion that exists on this issue. Smith, like previously Mike Shedlock, analyses Treasury yields only from an inflationary expectations basis.

Yet as I pointed out in my analysis of Shedlock's previous similar assertions, there are many factors that could move bond yields, and inflationary expectations is just one of them. There are other factors that are neutral from the point of view of inflation, and there is one way in which more inflation will lower Treasury yields: namely if the central banks starts to flood bond markets with liquidity by buying Treasuries and other bonds. Thus, far from being "contradictory" to a gold price rally, a bond rally (and the decline in yields this implies) could be very consistent with it.

Indeed, yesterday's dramatic price movements illustrate just how wrong Smith and Shedlock are in arguing that falling Treasury yields necessarily indicates a more deflationary (less inflationary) environment. No one in their right mind could possible believe that the news that the Fed will increase their planned asset purchases from $600 billion to $1.75 trillion and pay for those purchases by "printing money" could mean less inflation. Instead, it will of course mean more inflation. And so, if movements in Treasury yields primarily or even entirely reflected movements in inflationary expectations, then Treasury yields should have fallen yesterday. Instead, the 10-year yield plummeted from 3.02% to 2.52%, one of the biggest one day drops ever. This illustrates that the yield reducing effect from a greater money supply is very real, and often (including in this case) far more significant than the yield increasing effects of higher inflationary expectations.

This is not to say that it is irrelevant. While the yield gap between regular securities and inflation-protected securities is an imperfect measure of inflationary expectations (because the former are more liquid), its movements still gives you a hint of inflationary expectations. Tuesday March 17, the nominal 10-year yield was 3.02% and the inflation-protected 10-year yield was 1.90%. When this is written (the numbers may have changed slightly when you read this), the nominal 10-year yield was 2.52% and the inflation-protected yield was 1.21%. While the nominal yield thus dropped 50 basis points, the inflation-protected yield fell as much as 69 basis points, meaning that the yield gap thus rose 19 basis points.

The increase in inflationary expectations thus limited the decline in yields somewhat. But the expectations of massive money supply increases still overwhelmed that effect, as the 50 basis point decline in 10-year yields illustrated.


Blogger Reginald said...

In regards to Mike "Mish" Shedlock, I side with your point of view. Mish believes loan defaults and less credit amounts to deflation. As I see it, loan defaults don't destroy the money created - this money is being spent. Also, less credit just means slower inflation - disinflation. Lastly, assets prices have dropped, but consumer prices have remained stable unlike the Great Depression. In the end, I refer to Mises in the Theory of Money & Credit: if the aggregate increase in demand to hold money, is greater than an increase in money supply, it will lead to price decreases and vice versa. As always, it's in the hands of the people if hyperinflation will actually occur.

8:35 PM  

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