I actually feel uncomfortable doing a day-by-day analysis of how the markets are moving, as I have done for three days in a row. If I had wanted to be a trader or a market commentator, I would have become one. And various commenters have correctly pointed out that price movements have more than one possible interpretation. So it should be understood that all I am doing is adding my own, possibly eccentric, perspective to the mix for whatever it is worth.
With that disclaimer, I will observe that yesterday, the inflation expectations implicit in the TIPS spread on the 2-, and 5-year Treasuries both dropped by more than 10 percentage points, which are pretty significant daily changes, while the implicit expectations on 10-year Treasuries dropped by 9 points. Interestingly, although the S&P 500 was down for most of the day, it rallied in the afternoon and closed up by almost half a percent. But the yield on the 5- year conventional Treasuries actually rose by 2 percentage points, so that the implied real return rose a little more than expected inflation dropped. Even though the market loves inflation, it also likes higher real interest rates, so the real-interest-rate effect, I could argue, offset the effect of declining inflation expectations. But today the market is again dropping, with rates on the 5-, 10-, and 30-year Treasuries dropping by about 4, 5, and 6 percentage points. So it seems likely that both real interest rates and inflation expectations are again dropping. It doesn’t look good to me.
So let me now reply to Lars Christensen (and I hope that he will respond with some cogent observations of his own) who has been arguing that declining inflation expectations are not so ominous, because the Fed has managed to stabilize expectations in the 2 to 2.5 percent range, after having dropped to dangerously low levels last summer before Bernanke, supported by some key members of the FOMC, decided to initiate QE2. My concern is that the level of inflation expectations that you need to prevent an asset price crash such as we experienced in September 2008 is not necessarily fixed at a particular level, say 2.5 percent. In my view, discussed in more detail in my paper on the Fisher Effect, asset prices crash when the expected yield from holding real assets (which one can think of as being represented by the real rate of interest, though this is a huge simplification) is less than the yield from holding money which is the negative of the rate of inflation. Thus, when asset holders expect deflation, but very little return on real assets, they shift out of holding real assets into money, triggering a decline in asset prices until the expected rate of return on real assets rises enough to make holding real assets preferable to holding money.
This I believe is what was going on, along with a bunch of other bad stuff, in the fall of 2008. Investors were anticipating falling asset prices concluded that holding money was preferable to holding real assets and there was a crash in asset prices. The FOMC, instead of counteracting the fall in asset prices by cutting interest rates immediately and flooding the markets with liquidity, sat back and watched happily as the dollar soared in the foreign exchange markets, believing that they had finally broken the back of rising inflationary expectations over which they had been obsessing since commodity prices spiked in the spring. Job well done.
What I am afraid is happening now is that the expected yield from holding real assets has fallen sharply over the past few months. Six months ago in early February the yield on a 10-year TIPS bond was 1.39%, so in the last six months the expected real interest rate has fallen by more than 1%. Just since July 1, the yield has fallen by almost half a percent. There were a number of reasons for this. Oil prices spiked in February (not because of QE2 as so many now disingenuously allege, but because of the revolt in Libya and other fallout from the Arab Spring) followed by the earthquake and Tsunami in Japan, renewed debt problems in Europe, the farcical soap opera over the debt ceiling that has been playing out in the US, and downward revisions in US GDP, all of which have clouded prospects for future GDP growth to which real interest rates are closely connected.
Now last August when the economy was teetering on the verge of falling into a recession, the stock market declined by about 8 percent before QE2 was announced, the real interest rate on the 10-year bond was just over 1% and inflation expectations were barely over 1.5%. So if real interest rates have fallen by nearly 1 percent since last August, and expected inflation as measured by the 10-year TIPS spread is 2.28% as of yesterday, I think that we may again be in a danger zone. I hope that I am wrong. Lars?
UPDATE: Well I just saw Lars’s comment on the previous post. I guess I can’t look for any solace from that source? Anyone else care to offer some words of encouragement? Please.
UPDATE II @ 1:12PM EDST: On Bloomberg, I just saw that gold is now down $15 from its opening today (it was up earlier this morning). Does that mean that people are trying to get more liquid now? Query for Ron Paul, when people want to be more liquid, do they prefer holding gold or holding dollars?