Two titans of the bond market are still clinging to the idea that inflation is going to make a comeback.
Time and again, weak economic data have made the market’s inflationistas -- many of whom were beguiled by President Donald Trump’s pro-growth promises -- look a little foolish.
But for Vanguard and BlackRock, it’s only a matter of months before inflation is back at 2 percent. Regardless of what does (or doesn’t) happen in Washington, a tight job market will boost wages, lead Americans to spend more and push up consumer prices. Add to that a weak dollar and prospects the Federal Reserve will hold off raising interest rates until 2018, and they see a good chance the bond market is too downbeat about inflation.
The 10-year US Treasury yield today is just about where it was in early 2009. There has been great deal of back and forth trading in between but the reality is yields have gone pretty much nowhere for over eight years. In that time supply has increased substantially, but central banks have been buying up bonds at such a prodigious rate they have ensured the yield has stayed low.
I tend to think of the bond market in terms of Aesop’s fable of the boy who cried wolf. Over and over he jokes that wolf is coming so that eventually the other villagers ignore him. When a wolf eventually does appear, no one believes his cries and the flock of sheep is decimated. Inflation, at least in how central banks measure it, has been absent for a long time and there have been many false dawns. The failure of predictions about inflation might shade perceptions about its eventual return but do not affect its likelihood.
Central bank policy is gradually transitioning away from extraordinary accommodation not least because global growth is improving. That represents a massive transition and 2-year yields of 1.35% reflect a bond market reluctant to price even the smallest possibility of a return to an inflationary bias.
From a behavioural perspective, once we can identify the contradiction in a major market move we are closer to identifying what will be the epicenter of risk in the next crisis. Based on current yields, the bond market today assumes inflation has been conquered and there is nothing to be gained from hedging against its return. That seems like a very cavalier attitude when central bank policy is removing one of the most profound tailwinds for any market in history.