Everything Hinges on Inflation (Expectations)

A few weeks ago I wrote a piece about the flattening yield curves in the top five economies. The implication being that these economies are under duress, as investors forgo adequate compensation in favor of stashing their cash somewhere safe.

Before getting into the heart of today’s article, I want to show you a great chart that I came across. It’s a three-dimensional chart of the US yield curve.

This chart shows the entire yield curve, from the 1-month Treasury all the way to the 30-year Treasury, over the last two and a half decades.

The amount of information contained in this chart is incredible. I’m not going to go into a lot of detail, but there is something I want to point out.

The front of this chart (1-month Treasury) is influenced heavily by the Federal Reserve through its setting of the federal funds rate. But as you look farther out on the yield curve, to the 10-year Treasury and beyond, the Fed’s influence fades.

These “longer-term” rates are set almost entirely by the market. And they’re set by different forces. Instead of being actively managed by the Federal Reserve based on the performance of the US economy, the long end of the yield curve is determined by global investors based on two primary factors: inflation expectations, and risk premium.

To explain briefly, when you’re a lender (a bond holder), one of your primary concerns is how inflation will erode your purchasing power over the term of the bond. If you expect inflation to be higher, you’ll demand a higher rate of return (yield) on your loan. But if you expect inflation will be minimal, or nonexistent, then you’re okay with accepting a lower yield.

Don't miss Stoeferle: Helicopter Money Coming and It Will Boost Gold Market to New Highs

The other major factor that goes into the price of the bond is a risk premium – or compensation for bearing risk. With Treasuries, which are supposedly “backed by the full faith and credit of the US government,” default risk is minimal, which means risk premium tends to reflect how accurate your prediction of inflation is over the duration of the bond. (It can also reflect things like potential currency swings, particularly for international investors, but that’s beyond the scope of this article).

Risk premiums exist everywhere, but it’s important to understand that as particular investments become more competitive, risk premium erodes. Junk bonds are a perfect example. As demand for them rises, prices go up and yields fall – potentially without any underlying change in inflation expectations.

This massive “search for yield” is causing risk premiums on fixed income assets to erode almost entirely. For example, the 10-year Breakeven Inflation Rate (a measure of expected inflation over the next 10 years) sits at 1.52%. The current yield on the 10-year Treasury? 1.57%

The yield on the 10-year Treasury barely covers expected inflation. This means that there is little “risk premium” priced into the bond as compensation in case inflation over the next 10-years differs from current expectations.

Why does this matter? Two reasons.

First, this highlights the risk in owning bonds, including supposedly “no-risk” Treasuries. If inflation ends up being higher than currently expected over the next 10-years, there’s a good chance your money, once paid back, will not buy you what it would today.

Second, it means that bond prices and yields are likely to react especially forcefully to chance in inflation expectations. There is no buffer (risk premium) built in, implying that investors are walking a thinner tightrope.

Now, to circle back, the reason this article is titled as such is because inflation expectations are driving yields in fixed income markets, and yields in fixed income markets are dictating, in large part, how equities perform.

Check out Martin Armstrong: Throw Out the Fundamentals—Negative Rates Could Push the Dow Up to 40,000

If inflation expectations rise, yields on fixed income will rise, and stocks will lose some of their attractiveness. On the other hand, if inflation expectations fall further, fixed income yields will fall with them, and you’re likely to see more interest in stocks as a result.

So in my opinion, high stock levels are being driven by record low yields, which reflect both low inflation expectations and an absence of risk premium.

If inflation expectations rise (which I think is one of the last things on people’s minds right now) then both stocks and bonds are likely to fall.

Now if only I had an inflation crystal ball. Since I don’t, here’s the next best thing: current measures of inflation.

Notice that both measures (PCE and CPI) show a trend of rising inflation in both headline and core levels.

If you’re paying close attention, you might wonder why I’m insinuating that current levels of inflation may be a better predictor of inflation expectations than the actual 10-year Breakeven Inflation Rate (chart shown earlier).

This is my own theory, but it’s rooted in psychology. The truth is that none of us know what inflation will be like next year, let alone 5 years from now, or 10. It’s all one big question mark. And in these types of situations, a number of behavioral biases influence us in systematic and predictable ways.

To put it simply, a number of these biases reinforce the notion that we make our predictions of what’s to come based on what’s currently happening. Call it an amalgam of the Ambiguity effect, anchoring, attentional bias and the availability heuristic. Ultimately, it boils down to our natural inclination to expect that the future will be much like the present.

So to wrap things up, pay close attention to inflation figures, both here in the US and elsewhere. If they start ratcheting up, be prepared for both bonds and stocks to head lower.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()