Can we trust the bond market to get inflation right?

Outlook: The US data today is mostly the University of Michigan consumer confidence and inflation expectations, giving us time to digest the inflation data and the totally weird response to it. 

It’s hard to swallow but the report of high inflation was met with the benchmark 10-year yield falling to a 3-month low. This oddity reflects expectations of a high print being fully priced in, which hardly ever happens, and that discount is attributable to the Fed and its Big Bank gang, something that also hardly ever happens. The absence of contrary voices is remarkable. 

In fact, the 5-year and 100year inflation breakeven rates are about the same as three months ago and down off the highs. The WSJ has a remarkable observation—Breakevens are not “particularly high by historical standards. At around 2.47% a year over the next five years, the inflation currently priced into the bond market is above its historical level for most of the low-inflation period following the 2008 financial crisis. But from 2004-2007, which was hardly a period of booming inflation, that level was entirely normal.

“Analysts at Nordea note that bond yields are far out of step with their general relationship with inflation over the past 3½ decades. Core consumer price inflation of 3.8%, the level reported Thursday, has never been recorded in the post-1985 period alongside a 10-year bond yield of less than 6%. That indicates a fairly overwhelming belief on the part of investors that inflation is transitory.”

And “How good is the bond market at predicting inflation? Joseph Gagnon, the senior fellow at the Peterson Institute for International Economics, suggests that yields are far more closely correlated with past inflation than future inflation, though much of the data used predates the existence of inflation-protected bonds.”

In other words, we can’t trust the bond market to get inflation right.

While we are all fairly sick of looking at inflation stats, a case can be made that we really do have inflation in the US and a lot of it is not transitory. So-called shelter prices are up and not likely to retreat, being sticky downward--rents rose 0.24% in May, and owners' equivalent rent rose 0.31%. In addition, used cars are still up (7.2%) and that’s nearly a third of the CPI. And new cars are more expensive because of the chip shortage, raising questions about how transitory all car price rises will be. Household furnishing is at its highest since 1976. See the chart and table from the BLS. The highest numbers all have to do with energy in one form or another. We can’t expect these to fall out as special one-time pandemic items.

We have other oddities, too. If US inflation is about 5% and Japan has deflation, why is the yen not being sold down the river? This flies in the face of any conventional economic model you can find. College professors are in a pickle explaining this one when even long-time analysts are befuddled. Even the worst-managed currencies on the planet, the Turkish lira, and Russian ruble, are not being sold off.  

International affairs can have input into economics, even if at a distance and hard to trace. If Russia is being treated disrespectfully, it will be hard for Pres Biden to talk it into curbing cyber-attacks. If China is being treated disrespectfully, supply shortages of critical components can become endemic. We hate to acknowledge it, but these “loser” countries can have a big impact on western economies. Cue G7.

In Cornwall, G7 meets in person today for the first time in two years, the summit last year having been canceled due to Covid (but really because Europeans balked at paying Trump for using his Florida resort, the most brazen case of self-interest by a US president of all time and that includes Nixon). Topics are Covax (sharing vaccines), climate, cybersecurity, and China. Pres Biden meets Putin next week in Geneva and everyone wants to be a fly on that wall. We watched the press conference of Biden and Boris on the “special relationship” but could not detect any.

This time guests at G7 include India (at last), Australia, South Korea (hmm), and South Africa. After having been kicked out a few years ago, Russia was not invited. China may be suffering from a loss of face at not being invited. If G7 is the world’s largest/most important economies, China has indeed earned a place. Instead, it is getting insulted by the growing probability of incompetence at its labs that allowed the Covid 19 virus to escape.

Most traders would prefer to ignore geopolitics until sabers start getting rattled, but the global interdependence we have today makes that hands-off stance impractical. If some economies are red-hot, like the US and UK, they can get a dash of cold water from the new cold war enemies. It’s a new cold war, as so many observers have noted. We should not be building submarines and aircraft carriers—fighting the last war--but subsidizing cyber research and defenses against cyber attacks. This is so obvious that we wonder if it’s not going on already behind the scenes and just not disclosed to us mere mortals.

We expect the dollar sell-off to resume—drawing in Treasury investors who like the cheap dollar—until the inflation story heats up again, probably in the fall. Meanwhile, the Fed’s talk about talking about tapering will dominate next week and has some slight chance of encouraging the minority who see inflation as authentic and not entirely transitory.

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