The Great Inflation Debate
By Benjamin Streed
March 19, 2012
Last week saw a significant reversal of trend for the Treasury market, with yields across the curve spiking after the Fed released the results of its bank “stress tests” on Tuesday. Marking the occasion, 10-yr Treasury notes had their biggest weekly drop in over eight months and the 10-yr breakeven rate, a measure of expected inflation over the term of the debt, rose to 241bp, its highest level since last August. Further pushing the rally in yields were announcements on modest jobless claims as well as CPI data which fueled some speculation that inflationary pressures may be building up in the economy. This was partly a result of comments made by Federal Reserve Bank of Richmond President Jeffrey Lacker, who not only dissented with the majority opinion of the FOMC in its latest release, but he also indicated that he believed the fed funds rate will need to be raised “sometime in 2013”. He noted, “I dissented because I do not believe economic conditions are likely to warrant an exceptionally low federal funds rate for this length of time.” Also, “The economy is expanding at a moderate pace, and inflation is close to the committee’s 2% objective. As the expansion continues, the federal funds rate will need to rise in order to prevent the emergence of inflationary pressures.”
The key to the inflation debate is the timing of any potential rate increase, and the markets appear to slightly disagree with President Lacker’s forecast. Forward markets for overnight index swaps (OIS), which indicate the markets’ expected future federal funds rate, are only signaling a potential 0.25% advance in the key rate in late 2013 at the earliest, which leaves a very narrow window to adhere to Lacker’s stated timeline. Another inflation measure, the 5-yr/5-yr forward breakeven rate, which projects the anticipated rise in prices starting in 2017 for five years, sits at 2.56%. This is below its 2012 high of 2.62% and well off of its 10-year average of 2.76%. The markets are signaling that its inflation expectations haven’t changed much since the recent economic announcements and FOMC release, and if the markets truly believed in an inflationary threat we would see this breakeven rate rise to much higher levels. Lacker’s comments were surprisingly contrary to those of the FOMC consensus, which indicated that it will consider additional measures to keep interest rates low as well as pledging to keep benchmark interest rates at near-zero levels through at least 2014. The FOMC stated that inflation has been subdued in recent months but that the committee anticipates that subsequent inflation will run at or below its target rate of 2%.
The “Stress Tests” in Context
Last week’s announcement of the results of the Fed’s “stress tests” for U.S. banks showed some promise that the institutions are managing to shore up their balance sheets and help buffer against another potential downturn in the economy. The highly pessimistic scenario of 13% unemployment, a 50% drop in stock prices and a further 20% decline in home prices is drastic, but it does help clarify which institutions still have work to do. Only four institutions of the 19 failed in one or more measures (Ally, Citigroup, MetLife, and SunTrust) while the other 15 passed. It can be argued that results of the “stress tests” are a bit of a non-factor considering the bond markets’ muted response. YieldBook data show that financial spreads only narrowed 10bp to 228bp last week, while BBB-rated and A-rated indices tightened by 6bp and 7bp respectively showing little “stress test” effect on industry spreads. Last week may be a non-event for yield spreads, but looking at 2012 in its entirety paints a very interesting picture. Spreads on financial bonds have narrowed from a multi-year high of 366bp last fall to 230bp last week, a nearly 40% decline. Although some of the spread compression is a result of the general market appetite for corporate bonds, as industrial and utility spreads also narrowed, the relative decline in financial spreads is significant. U.S. financials are up 4.19% YTD while industrial and utility bonds are relatively flat at 0.44% and 0.11% respectively. For further comparison, BBB-rated and A-rated U.S. corporate bonds have returned 1.90% and 1.58% YTD respectively and Treasuries are -1.25%.
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