History Made: For Interest Rates or Inflation?

Well, we did it. Yesterday’s treasury auction was a resounding success. Investor demand for US Treasury bonds was very strong. This should shut the austerity hawks up, but I doubt that it will. Were the credit markets so squeamish about all that US government debt investors would not be flocking to buy those bonds in the great heaps they seem to be wanting to. There is a great logical black hole in the center of the austerity argument. Don’t go looking for them to admit it though.

Of even greater significance was the interest rate on yesterday’s inflation adjusted bonds: -0.55%. Yes that’s right. Negative 0.55%. Investors owe the Treasury. Not the other way around. This is an historic event. The reason that investors are willing to buy bonds with negative rates is that the government commits to hand over cash to compensate for inflation as well. So no one will end up paying the Treasury. Hopefully.

One way to get an idea of the likely outcome for investors in these bonds is to look at non-inflation proofed bonds of the same maturity. The difference between the two should give us a guide as to the expected inflation over the bond’s lifetime. More to the point these bonds are also a hedge against deflation: if we sink really deeply into deflation, investors in these bonds will have some protection, not as much as with inflation, but some nonetheless.

For example: if inflation rises to 4.0%, the bonds will earn 3.45%. That’s much better then the equivalent on a bond not protected by the inflation component. As of yesterday a non-inflation proof bond would have earned an investor about 1.2% over the same period. Meanwhile if we drop into deflation, let’s say of 2.0%, the bond will make a real return of 1.45% over the next few years. This sounds odd. Why isn’t the return -0.55% +(-2.0%) or -2.55%? Because you get the entire principal back on maturity. You invested $100, so you get back $100 even though deflation has occurred in the meantime. It’s the way the cash flows work out to maturity that counts. In an deflationary environment it is creditors who gain because they are paid back in devalued dollars, but they still get full value back. It is the debtors who bear the brunt of deflation because they pay back with deflated dollars. The purchasing power a debtor borrowed is less than the purchasing power they pay back.

Is any of this important?

Yes.

It tells us that the credit markets think we are heading into a period of rising inflation. That they are prepared to buy an insurance policy against high inflation – they are willing to fork over that 0.55% – tells us that they feel they need to protect themselves.

But where is this inflation going to come from?

From QE2. For some reason the credit markets have bought into the austerity hawks notion that the impending flood of dollars from the Fed’s next round of easing, aka QE2, will inevitably lead to a burst of inflation. Hence the need for a hedge. The market is wrong. Again. I just don’t see how, with all the slack in the economy, we can expect a burst of inflation. History and theory both argue we are in for more disinflation. Apparently the market is running with the hawk’s version of market psychology where we are about to be confronted with fear crazed investors all demanding high yields to protect themselves from the rampant inflation all that money sloshing about will cause.

Or not.

The problem with this view is that it is entirely made up. There are no facts to support it. Indeed yields are still dropping. Just this morning two year Treasuries hit an all time low. Disinflation continues. For there to be any semblance of substance to the inflation burst view we need to get beyond the current massive over-capacity in the economy. There is simply too much slack to justify price or wage increases. Only when that slack is worn off will we face inflationary pressure, and by then the Fed will be well placed to rein inflation in through normal open market operations – they can sell down the portfolio they are now accumulating to sop up cash. So inflation is unlikely to surge under any account.

A more interesting point is whether, given all this confusion over prices, the Fed should simply announce a hard target for inflation. This would have the effect of eliminating any doubts about intentions. And it would add clarity, or an explanation, for any actions the Fed took. It would provide a context within which investors could make decisions rather than having to guess, as yesterday’s historic event suggests is what they are currently doing.

Either way, the next Fed meeting on November 2nd/3rd should be eventful. I expect QE2 to be launched. And I expect it to have little effect, but that’s another story.