The Focus Turns to Bonds, Interest Rates and Inflation

As the benchmark 10-year Treasury Note inches higher, closing in on 4%, the chatter about interest rates and inflation is heating up.

The subject is all the more topical in the wake of last week’s encouraging jobs report. If the economy is gaining “momentum,” as former Fed head Alan Greenspan said yesterday, it’s only natural to expect higher rates. But how much is too much? The economy may be improving, but there’s still a long road of mending ahead. Warranted or not, the price of money is rising. As our chart below shows, the 10-year yield is just under 4%. That’s the highest since last June.    

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Are even higher rates coming? Yes, according to some bond bears at the outer edges of current forecasts. “Treasury rates will soar,” Kazuhito Miyabe, who assists with managing foreign fixed income in Tokyo at Toyota Asset Management Co., tells Bloomberg BusinessWeek.

Is inflation also headed higher? Not likely, at least not in dramatic fashion for the foreseeable future. The market outlook for inflation, based on the spread between the nominal and inflation-indexed 10-year Treasuries, remains modest at around 2.25%. That’s up sharply from the near zero percent range of late-2008, when the market feared a deflationary implosion. The low-2% range of late is merely a return to levels that prevailed before the financial implosion of September 2008. Yes, inflation’s likely to creep higher, but it’s unlikely to surge in the short term.

Nonetheless, this is no time for complacency on the matter of pricing pressures. Inflation appears to be bubbling, if only modestly, around the world. From Brazil to Australia, central banks are starting to focus on inflation. Rate hikes are still rare, but that too will change as the year rolls on. Consider, for instance, that Mexico, Brazil and South Africa, to name a few countries, have officially raised their inflation projections.

For U.S. policy, debating if inflation is, or isn’t, a clear and present danger going forward is topical within the Fed. As The Wall Street Journal reports today,

The Federal Reserve’s decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.

But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.

The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.

Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures.

Expectations about future inflation may hinge on whether there’s a consumer-spending response to last week’s news of March’s robust round of job creation—the first significant increase since the Great Recession began in December 2007. Minting new jobs in substantial numbers is one thing. Will that lead to a material boost in consumer income and spending? Maybe, although we’ll need to see the March gain in jobs creation roll on through the spring and summer to make a convincing case.

Meantime, there are new hurdles looming, starting with this week’s Treasury sale of a hefty chunk of new government debt. Last week’s selling in the bond market, which drove yields higher, was an act of standing back to see what happens next, according to one strategist. “No one wants to stick his neck out before the auctions,” George Goncalves, head of U.S. interest rate strategy at Nomura Securities in New York, told Reuters late last week.


Originally published at The Capital Spectator and reproduced here with the author’s permission.
 
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