Is the bond market anticipating inflation?

There has been a considerable amount of talk lately about potential higher inflation coming, and the anticipation of that has been reflected in the bond market. In early 2020, before any of us had ever heard the word Covid or Pandemic, the yield on the U.S. 10 year Treasury bond was approximately 1.75 percent. As the stock market crashed in late February to late March of 2020, the yield dropped to approximately 0.60 percent as investors fled the stock market and moved money into bonds for safety. Now we have almost come full circle. As I write this in early March, the yield is back up to approximately 1.6 percent. The question now is whether this a predictor of future inflation or something else? We’ll soon see.

The U.S. money supply is divided into three categories — M1, M2, and M3 — with each category progressively less “liquid” in terms of how quickly it can be accessed and spent. The M1 category includes:

• Physical cash and coins.
• Demand deposit bank accounts (the type from which cash can be withdrawn at any time).
• Other liquid forms of money.

If you want to see the most obvious case for why inflation is a risk in 2021, it might just be a chart showing the trajectory of M1 over the past year. I don’t have the chart here, but you could look it up on the Federal Reserve Bank of St. Louis’s website.

The chart shows M1 dating back to 1996 and tells a story in three parts. Before the global financial crisis of 2008, the rise in M1 was fairly tame compared to what came next. An increase occurred in the early 2000s, but it hardly registered relative to what followed. After the 2008 crisis, M1 started to rise aggressively, heading up for more than a decade as the Federal Reserve maintained various quantitative easing (Q.E.) programs.

Then came the $2.5 trillion stimulus package passed by Congress in 2020. As a result of pandemic-fighting measures, both monetary and fiscal, M1 went straight up. Instead of moving up on the chart at a steady incline as before, it seemed to simply spike straight up. The portion of M1 that sits in bank accounts (demand deposits) can be used by the banks to make new loans and can also be spent by consumers. When lending and spending pick up in line with a vaccine-powered recovery, some economists think that all of this liquidity will contribute to inflation as prices for goods and services start to rise. This is basic Economics 101.

In late February and early March, the bond market started to take the possibility of inflation seriously. Ten-year inflation expectations are now above 2 percent for the first time since late 2018, and the yield on the U.S. 10-year Treasury bond is above 1.5 percent for the first time since March 2020, as I mentioned above. However, even though inflation expectations and the 10-year nominal yield are both rising, the “real” yield has gone more negative than ever.

The real yield is the nominal (actual) yield minus the inflation percentage. So, for example, if you own a bond that pays 1 percent, and inflation is 2 percent, you come out with a 1 percent loss of your purchasing power because inflation eats up your gains. And if inflation expectations are rising faster than interest rates, negative real yields can become even more negative. That is exactly what we are seeing, as the Federal Reserve charts show. Even with nominal interest rates rising now, the real yield on the 10-year has not been this negative in decades because inflation expectations are rising faster than yields now.

From a Federal Reserve point of view, negative real yields are not a problem. That is because when real yields are negative, it means the debt burden is being inflated away. We often ask how we will pay off this monstrous debt load the U.S. Government has created. The answer is, in my opinion, we can’t and won’t. Inflation effectively decreases the monetary value of debt as it is paid (partially) with cheaper dollars. This is a helpful thing when government debt levels are set to explode. It doesn’t help you individually unless you are carrying a lot of debt.

The important question is, what happens next? Interest rates can theoretically rise as long as inflation expectations rise faster, with inflation continuing to erode the debt burden. But if interest rates rise too far and too fast, it could mean trouble for stock market valuations since much of that is currently supported by low interest rates. It could even threaten the economic recovery.

The Federal Reserve will have to pull off an extra tricky balancing act moving forward. On the one hand, the Fed will want inflation to run a little bit hot (above 2 percent) as the U.S. economy recovers, and a modest rise in long-term interest rates can comfortably go along with that. But if inflation starts to get too hot or interest rates start to spike as investors flee the bond market, the Fed could be forced to take new emergency actions. I personally think that inflation is coming but not for another year or so in any large amount. We’ll see.

The four-way interplay here between interest rates, inflation expectations, stock market valuations, and the economic recovery outlook will be important to watch in the year ahead. I’ll be watching and will let you know my thoughts as the outlook becomes clearer. Thanks for reading.