What Inflation Says About Bonds & The Fed
As of late I have been running counter to the mainstream economists and analysts who have been calling for the end of the "bond bull" market and the "great rotation" from bonds into stocks. This is a topic that I have covered previously when I wrote "Why Bonds Aren't Dead & The Dollar Will Get Weaker" wherein I stated:
"There have been quite a few bold predictions, since the beginning of the year , that the dollar was set to soar and that the great 'bond bull market' was dead. The primary thesis behind these views was that the economy was set to strengthen and inflation would begin to seep its way back into the system. Furthermore, the 'Great Rotation' of bonds into stocks, on the back of said economic strength, would push interest rates substantially higher.
While I have no doubt that at some point down the road that inflation will become an issue, interest will rise and the dollar will strengthen - it just won't be anytime soon. A wave of 'disinflation' is currently engulfing the globe as the Euro-zone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets."
That wave of disinflation continues to much more prevalent than previously expected. The latest inflation readings (both the Producer and Consumer Price Indices) show deflationary forces still at work. The core reading for PPI declined in May to 1.6% while CPI remained flat at 1.7%. However, PPI and CPI mask the true economic pressures on the consumer as wage growth remains stagnant, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber which indicate weaker levels of economic output both domestically and globally. The battle against the deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like "Humpty-Dumpty", the broken financial transmission system, as represented by the velocity of money, has not been put back together again.
The chart below shows the Composite Inflation Index (CII) which is an average of both PPI and CPI versus economic growth.
There are two key takeaways from this analysis: 1) Deflationary pressures are more prevalent, at the moment, than inflationary ones; and 2) The CII points to weaker economic growth in the coming quarters which is likely to keep the Fed on hold for a while longer.
Both of these issue point to why the "Great Rotation" has yet to occur. Despite the Federal Reserve's ongoing efforts to inflate asset prices; such inflation is not translating to "Main Street" in the form of higher wages, increased consumption or higher standards of living. The Federal Reserve has often discussed that there are limits to monetary policy and they may have found those limits in its most recent endeavors.
Secondly, the decline in inflationary pressures say much about the actual economy. Historically, declines of this magnitude have been associated with economic weakness and recessions. The current liquidity driven interventions have worked to drag forward future consumption to keep current economic stable but has failed to substantially boost it.
More importantly, if the Fed is truly about to start tapering bond purchases, the historical evidence shows that interest rates fall, rather than rise, following such withdrawals of artificial stimulus. The chart below shows that the recent surge in interest rates is consistent with past liquidity programs from the Fed but the withdrawal of those interventions will likely send rates lower as money rotates back to "safety."
As I stated recently in my discussion on "Interest Rates Vs. The S&P 500":
"However, before you get to excited, look back at that red circle in the lower right corner of the chart [below]. It is important to keep in perspective the recent "surge" in interest rates that has gotten the market's attention as of late. In reality, this is nothing more than a bounce in a very sustained downtrend. Is the bond 'bull market' extremely long in the tooth? You bet. Does that mean that interest rates are set to surge higher in the near future? No."
Reported inflation, or lack thereof, continues to show that there is still not enough economic strength to pull the "life support" from the patient in the short term. While there is not a tremendous amount of downside left for interest rates to go currently - it also doesn't mean that they are going to substantially rise anytime soon as weak economic growth, an aging demographic and rising governmental debt burdens combine to keep inflationary pressures in check.
With this in mind it is highly unlikely the Fed will substantially reduce interventions in the short term. More likely the Fed is likely to try and talk markets down by increasing expectations of future declines in bond purchases. Most importantly, however, the Fed will likely emphasize their "accommodative policy stance" going forward. In a weak economic growth environment the Fed cannot begin a program of boosting overnight lending rates. As the chart below shows, every time the Fed has embarked on such a program to increase borrowing costs it has led to an economic recession or worse.
The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a "soft patch" currently despite the mainstream analysts' rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the "liquidity trap" they have gotten themselves into without cratering the economy, and the financial markets, in the process. As we said recently this is the same question that Japan is trying to figure out as well.