U.S. treasury yields are relatively low these days with 10-year government bonds offering just 3.63%.
This would seem to imply that bond markets don’t expect much inflation ahead, since even a historically benign 3% inflation per year wouldn’t leave much of a real return for bondholders.
So is the bond market telling us to chill out or is it completely blind right now?
It’s blind, says Morgan Stanley’s Joachim Fels. Historically, bond markets have usually been wrong when it comes to forecasting future inflation:
Joachim Fels @ Morgan Stanley:
Historically, yields lag behind inflation. Throughout the 1970s, bond yields never meaningfully caught up with the inflation takeoff: real interest rates were mostly very low – indeed negative for sustained periods – a bad time for bonds. Exactly the opposite happened during the Great Moderation of the 1980s and 90s. The sustained decline in inflation meant real interest rates were high, giving rise to a long bull market for bonds (see Exhibit 2).
Thus Mr. Fels worries that treasuries will be wrong yet again. High inflation is in the cards because despite whatever inflation environment we may see today, the fact is that high levels of U.S. debt make high inflation and sluggish GDP growth highly probable:
Which means that if one were to simply play the odds, then today’s bond market is likely to be wrong and higher inflation is likely to happen. We could start to see this play out in the second half of this year.
Morgan Stanley: Yet inflation is low almost everywhere. And with yawning output gaps, surely inflation is nothing to worry about. Policymakers, some say, couldn’t inflate even if they wanted to.
Not quite. It is true that inflation will remain subdued for some time to come. But inflation risks are visible on the horizon. Our US team expects the inflation picture to turn at around the middle of the year, as import prices pick up and the output gap narrows
(Via Morgan Stanley, Global Monetary Analyst, Joachim Fels, 3 March 2010)
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