Flight to quality?
Since June, bond yields have fallen to the point where the U.S. government is getting paid to borrow money right across the entire yield curve. The 10-year is 3.8%, while inflation in the U.S. is 5.6% . What gives? This is either a flight to quality or a harbinger of hard economic times.
Inflation expectations are so weighted down that investors are buying 10-year Treasuries yielding 3.8 percent with inflation running at 5.6 percent.
Federal Reserve policy makers couldn’t ask for a stronger mooring in the face of disappointing inflation news. A pair of reports on consumer and producer prices for July showing year- over-year increases of 5.6 percent and 9.8 percent, respectively, the fastest pace in 17 and 27 years, failed to rattle the U.S. Treasury market.
There are two schools of thought on why Treasuries are expensive relative to inflation and an expected onslaught of supply to finance the growing federal deficit. The Bush administrationa record $482 billion deficit in the fiscal year that begins Oct. 1.
The first holds that bonds are mispriced. Buyers are either complacent or smoking something stronger than tobacco. Even if they are in full command of their faculties, they are choosing liquidity over yield.
“Investors are willing to take a lower yield on risk-free investments” in light of questions about the solvency of Fannie Mae and Freddie Mac and systemic risks the Fed is working to mitigate, says Greg Ehlers, a managing partner at Navigate Advisors, a Stamford, Connecticut, brokerage firm.
The other school sees the market as forward-looking. Inflation may be elevated now, but bonds are telegraphing better (inflation) or worse (economic) news, depending on one’s reference point, ahead.
Investors may be willing to accept a lower yield in exchange for assurances of timely payment of principal and interest. But why would they knowingly tie up money for 10 years in anticipation of a negative return when they have the option of investing for a shorter term or buying inflation-indexed bonds (TIPS), which offer a real yield plus compensation for actual inflation?
Answer: Because enough folks expect the great deleveraging under way, with its contractionary effect on money and credit, to pare inflation so that the return on a nominal 10-year note will exceed that on 10-year TIPS.
While I happen to think the bond markets sense an imminent fall in inflation, c’mon: a negative 1.8% real return on the ten-year is ridiculous. Given the gapping out of spreads on Fannie and Freddie, the talk of the GSEs needing $100 billion and the talk about Lehman Brothers selling out to anybody with available cash and having their credit lines pulled, it doesn’t take a genius to figure out fear is rampant in the markets.
Does it really matter? Both potential scenarios are dramatic to the extreme. Behind Door #1: you have a tapped out consumer, crashing the economy and taking inflation down with it. Behind Door #2: you have A major bank or Fannie and Freddie going belly up and needing a huge bailout. Pick a door.
Either way you look at it, we’re in for some turbulent times.