Bond Market Continues to Record Falling Expectations of InflationAuthor: John MasonLast Updated: November 22, 2014 The inflationary expectations investors have built into the bond markets crashed through another level this week.The 10-year inflationary expectations calculated from subtracting the yield on the 10-year Treasury Inflation Protected securities (TIPS) and the regular 10-year Treasury note dropped below 1.90 percent on Monday, November 17.This decline represented a continuation of falling expectations of inflation that have been recorded in the bond market since July of this year.On September 26, inflationary expectations fell below 2.00 percent. On September 17, they dropped below 2.10 percent. On August 20, expectations declined below 2.20 percent. And, on July 14, inflationary expectations fell below 2.30 percent.It seems as if investors are preparing themselves for an extended period of very modest inflation…something below the Federal Reserve’s target for inflation, which is 2.00 percent.Seems as if disinflation…or even deflation…is on almost everyone’s mind these days.The economy in the United States is weak. In the third quarter of 2014, the US economy grew, year-over-year at a 2.3 percent annual rate. Over the previous five years, the economy grew at a compound rate of growth of 2.2 percent.And, the price index the Federal Reserve officials follow most closely rose in September at a 1.4 percent annual rate.The eurozone economies grew at a 0.6 percent, year-over-year rate in the third quarter and inflation has been declining in a pretty steady fashion there and is now at a 0.4 percent year-over-year rate. Deflation talk is in the air.Japan has just fallen into another recession and the latest consumer price index is roughly what it was 15 years ago.And, the world economy seems to be weakening…this along with oil prices falling to their lowest level in four years.Deflation talk has even reached the United States in a op-ed piece in the Well Street Journal by University of Chicago economist John Cochrane, “Who’s Afraid of a Little Deflation?”.I have even added my own thoughts to the matter: see “Deflation?” and “Deflation?–A Follow Up.”This talk has taken most observers of the bond market by surprise. Last December almost all of us were expecting longer-term interest rates to rise. On December 31, 2013, the 10-year Treasury note closed to yield slightly more than 3.00 percent.This week the 10-year is trading to yield around 2.30 percent…a 70 basis point drop.This situation is causing the officials at the Federal Reserve some concern.Supposedly the Federal Reserve is looking to see short-term interest rates rise within the next year… and along with this, officials were looking for longer-term rates to rise as well.The problem the Fed faces on this issue is strength of the economy. The general assumption has been that the economic growth will start to pick up and this will, hopefully, put some pressure on the banking… which, will put a little pressure on the money markets and short-term interest rates will begin to rise. This scenario is the ideal one for the Fed’s attempt to get these rates to rise.Right now, there is little or no pressure on the money markets. The effective Federal Funds rate is trading well within the Federal Reserve targets and lingers around eight to nine basis points.The yield on the 2-year US Treasury note has risen slightly since inflationary expectations dropped below 2.30 percent on July 17. At that date, the 2-year yielded 0.460 percent. At the close of business on November 19, 2014, the 2-year yielded 0.523 percent, a rise of 63 basis points.I would argue that at least 40 basis points of this 63 basis point rise came from “safe haven” money from Europe that, during the past four months has returned to Europe as European bond markets have settled down.The rest of the increase came from a slight reduction in the “liquidity” of the financial markets. The liquidity measure that I use (derived from the yield on US Treasury securities in the Fed’s H.15 statistical release, divided by the yield on Aaa-rated bonds…from the same source) has dropped from about 61.0 during the week ending July 18, to a low of about 57.0 reached during the week ending October 24. It is now back up to 60.0. Note that the weeks of October 17 and October 24 were the weeks when wide swings took place in the bond…and stock markets.This helps me to explain fluctuations in the market that occurred over the past several weeks, but the bottom line is still that inflationary expectations have fallen significantly over the past four months but little pressure has been felt in the money market to really push up interest rates there.In the longer-term end of the bond market, the yield on the 10-year Treasury note rose from about 2.55 percent on July 14 to around 2.35 percent at the close of business on November 19.The result here is that the term structure of interest rates flattened out…which is not exactly what was expected in the situation the Fed now finds itself.There are few…if any…precedents for this environment.So the Fed is confounded. What about investors?Maybe this can be depicted in the other measure that I use from the H.15 report of the Federal Reserve. This is what is called the “confidence” measure and is derived by dividing the yield on Aaa bonds by the yield on Baa bonds.In the middle of July 2014, the “confidence” measure was around its near term high of 88.8. In the week of November 7, the measure hit a near-term low of 81.9. The conclusion one can draw from this is that there has been a significant erosion of market confidence over the past four months. That is, the risk being built into securities with lower credit ratings has been increasing. Or, as uncertainty has risen in the market, investors have moved from securities with lower credit ratings to securities that have higher credit ratings.The economies of the world are not doing too well. Deflation seems to be a real possibility. The Federal Reserve is in uncharted territory. And, there is political uncertainty in Russia/Ukraine, the Middle East, in the eurozone…and in the United States.And, this means to me that in the near future we might expect greater volatility to rule to bond markets. About John Mason John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.