July 10, 2019 / 1:44 PM / 11 days ago

Breakingviews - Hadas: Bond markets lost in inflation-growth gap

LONDON (Reuters Breakingviews) - Bond markets respond rationally to news in the short term and the long term. The medium term is another matter.

Traders work on the floor of the New York Stock Exchange as Federal Reserve Chairman Jerome Powell holds a news conference on the television behind them in New York, U.S., June 19, 2019. REUTERS/Lucas Jackson

Leave aside the question of whether yields on government bonds actually make sense. It takes some mental gymnastics to explain why investors would lend to the United States for 10 years at 2% when the inflation rate is 1.8%. Buying 10-year German government debt at a yield of minus 0.3% requires even more elaborate contortions. But even if the base is wrong, short-term shifts make sense.

Consider the reasoning behind last Friday’s sudden rise in the yield on 10-year Treasury bonds – from 1.96% to 2.06% in a few minutes. A surprisingly strong report on American job creation indicated a faster-growing economy, reducing the likely amount of future monetary stimulus from the U.S. Federal Reserve. This in turn pushed up the likely yield on shorter-dated bonds, which made the yield on longer-term paper look unreasonably low.

The chain of reasoning is long, but traders think fast. Indeed, their response to good or bad economic news is well honed almost everywhere. Similarly, bond investors have a consistent and reasonable reaction function to news about movements in inflation. All else being equal, yields rise whenever there is an unexpected increase in retail prices, and fall when it turns out prices aren’t rising as quickly as anticipated.

The data can send contradictory signals, so instantaneous reactions sometimes turn out to be wrong. However, traders tend to worry more about the next few weeks than what happens in the years ahead, so they do not need to fret about how the economy actually works. Since the big question for them is how central bankers will respond, market participants only have to understand how policymakers think the economy works.

This agnosticism has served investors especially well in dealing with quantitative easing – the central bank practice of buying bonds with newly created funds. No one really knows how QE affects companies’ hiring decisions, investment rates or inflation. However, traders could anticipate the short-term effect on financial markets. At the margin, central bank buying pushed prices up, and thus yields down.

Markets are not only clever in the short term. They have also been somewhat wise over several decades. Look at U.S. inflation rates and yields on U.S. Treasuries. Both showed a rising trend from the 1950s to the end of the 1970s, and a subsequent decline.

The wisdom was fairly slow in coming, though. When the annual inflation rate fell below 7% in 1982, for the first time in four years, the 10-year yield was still 14%. Inflation then fell further, averaging 4% over the next decade. But bond yields did not fall durably below 6% until 1997.

The current yield on 10-year Treasuries is just about equal to the current U.S. inflation rate. It may therefore seem that investors have learned that pressure on prices is durably lower than in the past.

That’s not quite right, though. Look at what happened between July 2017 and October 2018. The 10-year U.S. bond yield rose from 1.4% to 3.2%, largely because investors thought inflationary pressures were gathering. According to most of the standard explanations of how prices behave, the ingredients were there.

The unemployment rate was falling as growth picked up. The U.S. fiscal deficit was likely to rise as a result of Donald Trump’s tax cuts. Meanwhile, the Federal Reserve was perceived to be reluctant to raise overnight interest rates too fast, for fear of disrupting the financial system or angering the president.

Inflation did indeed rise, but only slightly. In the first half of 2017, the average monthly rate was 2.2%. It peaked at 3% in July 2018, and is now back below 2%, even though the labour market remains strong.

This was far from the first false inflationary alarm. The economist Paul Samuelson famously quipped that the stock market had forecast nine of the past five recessions. By the same token, the bond market has prematurely predicted an end to declining inflation eight times. There are likely to be more false dawns, since there are always investment advisers forecasting that rising commodity prices, labour shortages, bad policy, or overheated growth will lead to rising prices.

As yet, though, inflation remains dormant in every country with even vaguely sensible monetary and fiscal policies. Only 16 nations of the 188 followed by Trading Economics have inflation rates above 10%. The global midpoint is Canada with 2.4%.

Economists have not found a persuasive explanation for the persistence of low inflation. Since they do not understand why it is happening, they are unlikely to be able to identify a turning point. Until then, markets are likely to do what they often do – overshoot and undershoot, but not by too much or for too long.

Breakingviews

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