Commentary on Political Economy

Monday 27 September 2021





There was a big happening in the bond market over the last few days. Or was there?

It’s certainly been a bad few days for bond investors, reflected by a sharp increase in Treasury yields. The 10-year yield is still below its high for the year, set in the spring when anxiety about inflation was at its peak. But it has broken back above its 100- and 200-day moving averages, suggesting that the trend is firmly upward once more:

It’s my job, and that of many subscribers to this newsletter, to watch the 10-year yield like a hawk. It’s probably the single most important rate in global finance. But let’s not get too carried away. If we look at five-day rises over time, the change since last Tuesday does show up on the chart — but there have been more than a dozen weeks when yields rose by more, in the last five years alone:

So when should we start to pay closer attention? Here it is necessary to offer, for the nth time, the chart of the strongest trend in finance. It’s the trend on which all others depend, and on which many financial engineering fortunes are built. Since the Federal Reserve gained control over inflation in the early 1980s, the 10-year yield has trended down in an almost perfect sloping line. The peak of each oscillation is lower than the one that precedes it. And every time the bond yield rises to threaten or briefly cross the trend line, there is a financial accident. The 10-year yield reached the top of its trend ahead of: the Black Monday crash of October 1987; the bear market generally associated with Iraq’s invasion of Kuwait in 1990; the Tequila Crisis and the Orange County derivatives debacle of 1994; the bursting of the dot-com bubble in 2000; the subprime crisis in the summer of 2007; and the “Christmas Eve Massacre” at the end of 2018. 

On all occasions, yields soon fell, usually thanks to lenient monetary policy, and the bond bull market carried on. We don’t know from experience what would happen if yields were to keep rising. but it wouldn’t be pretty. However, as the yield needs to get above 2% to cause problems, and currently stands at about 1.49%, there is some room yet before a bond scare prompts the next financial accident: 

What will cause a breakout? With apologies to James Carville, it’s inflation, stupid. The relative performance of stocks compared to bonds has moved almost perfectly in line with 5-year market-based inflation breakevens throughout the pandemic period. A collapse in the spring of last year was followed by a steady rise in both — the “reflation trade.” For the last six months or so, however, the two have traced each other. Stocks have been flat relative to bonds, and inflation breakevens have been steady:

The latest surge in yields doesn’t change this. But it does help illuminate what we have to be worried about. If inflation is transitory or broadly under control, the Fed can keep up the generous monetary policy that will keep the stock market afloat. If inflation takes off, however, it has a choice between allowing that inflation to let rip, or hiking rates, and provoking the next financial accident. 

The latest move in the bond market is interesting. What really, really matters, is inflation. And that picture remains unclear. 


Inflation Indicators

As luck would have it, the latest inflation indicators are out, and they suggest that it is still far too early to relax and declare that the current dose of inflation is transitory. You can find the full set of indicators, regularly updated each week, here

The summary “heat map” appears below. As this has caused confusion, let me explain what it shows. Each rectangle is a different indicator. There are 35 in all. The rectangles are colored according to how much they differ from the norm over the last decade (a period when inflation has remained more or less totally under control in the U.S. and western Europe). If it is dark blue, the indicator is way above its norm — suggesting inflation is becoming a problem. If it’s grey, then it’s below average. 

The indicators are arranged in lines to help see where inflationary and deflationary pressures are coming from. The top line is formal measures of inflation (CPI, PPI, and so on), the “market indicators” include breakevens and measures from bond markets, the consumer and business sentiment line includes ISM surveys and so on. I chose the 35 indicators earlier this year, and a number of them were judgment calls. They’re my best attempt to capture the full inflation picture. Here is the current heat map:

So, to interpret, the economic measures look terrible (and we have to hope they’re transitory), and business sentiment is terrible, but the market seems unconcerned and experts polled by Bloomberg (in the bottom line), don’t seem bothered. The biggest cause for concern, in my opinion, is that wages are unmistakably picking up. This is a great thing in many ways, of course, but it is bad news if you’re hoping to keep the lid on inflation. 

I hope that helps. Go to the indicators page, or even bookmark it, and you can watch inflationary pressure rise or fall over time.  

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