Inflation and Treasury Bonds
Oct 20, 2010
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 17th October, 2010.
You can track what's happening to money-supply growth at True Slant. What we generally refer to as TMS (True Money Supply) is called TMS2 at the afore-linked web site.
As at the end of September, our preferred measure of US money supply (TMS2) had a year-over-year growth rate of 11.2% and had spent 20 months in double digits. This obviously constitutes substantial monetary inflation, although apparently not substantial enough for the Fed. The year-over-year growth rate of TMS1, a narrower measure of US money supply that doesn't include savings deposits, was 4.9%. The growth rate of TMS1 has been slow enough over the past few months to boost the convictions of some deflation forecasters, but note that it is now rising.
The bean-counters at the ECB haven't yet completed their money-supply calculations for September (this is what happens when you give people 6 weeks of annual holidays), but August figures reveal a year-over-year growth rate of 8.1% for euro TMS. Europe's inflators are therefore lagging their US counterparts, although they are still doing yeoman-like work. The euro is in no danger of maintaining its purchasing power.
The following chart from Fuller Money shows the yield on the standard 10-year Treasury Note minus the yield on a 10-year TIPS (an "inflation-protected" 10-year Treasury Note). We refer to this yield difference as the "expected CPI" because it reflects the market's guess as to the average CPI that will be reported by the US government over the next several years.
The chart shows 2008's dramatic plunge and 2009's equally-dramatic rise in inflation expectations. The people who talk about the Fed "pushing on a string" should take a look at this chart. The US experienced the greatest financial de-leveraging in its history during the second half of 2008 and the first quarter of 2009, and yet not only was the Fed able to engineer a massive increase in the rate of monetary inflation, it was also able to bring inflation expectations back to near the middle of their 2005-2007 range within the space of only 12 months. The Fed can't promote real economic growth, but it will always be able to depreciate the dollar.
Zooming in on this year's performance of the "expected CPI", there was a sharp decline during May-July and then a sharp rebound beginning around mid August. The August-October rebound in the "expected CPI" has coincided with big rallies in commodity and equity prices, and has, we think, been driven to a large extent by the anticipation of QE2. The T-Bond market has held up remarkably well during this period, probably because the Fed has made it clear that it plans to depreciate the dollar by monetising Treasury debt.
The major risks for Treasury Bonds
As we see it, the three most important risks facing the market for US government bonds are:
1. US Government default
Debt that cannot possibly be paid off will eventually be written off, one way or another. When all of the US Federal Government's obligations are taken into account it is clear that these obligations cannot be paid and that default is inevitable, but the timing and nature of the default are unknowable.
Most of the people who recognise the inevitability of default assume that it will happen indirectly via inflation, but we aren't so sure. The nature of the default will be determined by politics, and from a purely political perspective it may be more feasible for the US government to directly default on its debt. The reason is that foreigners hold a lot of the debt. Consequently, much of the cost of a direct default would be borne by foreign investors and foreign central banks, whereas the US economy (the US voting public) would be the biggest loser from default via inflation.
2. Fed monetisation leading to rising inflation expectations
Fed monetisation of US Treasury debt will only be supportive of T-Bonds until inflation expectations begin to rise rapidly in response to the monetisation, at which point additional monetisation of Treasury debt will become counter-productive.
It should be kept in mind that most, if not all, of the hyperinflations of the past 100 years, including the famous Weimar hyperinflation, were set in motion by central bank monetisation of government debt.
3. Large-scale selling by foreign central banks
It is widely believed that foreign central banks, such and the Bank of China and the Bank of Japan, accumulate US Treasury debt in response to trade imbalances, but this is not true. The aforementioned accumulation of US government bonds is done in an effort to SUSTAIN the imbalances. For example, when a Chinese manufacturing company receives US dollars in exchange for products shipped to the US, the Bank of China is under no obligation to purchase these dollars and to then exchange them for Treasury Bonds. Instead, it CHOOSES to take this action to prevent the Yuan from gaining against the US$ and to maintain the trade-related status quo.
At some point, foreign governments and central banks are going to realise that their economies are being damaged by their efforts to support exporting industries. At this point the foreign CBs will become large-scale sellers of US Treasury debt.
If foreign CBs became large-scale sellers of US Treasury debt then the US authorities would likely react in one of two ways. The first would be to immediately default on the debt, causing Risk #1 to materialise. The second would be for the Fed to accelerate its monetisation of T-Bonds, bringing Risk #2 to the fore.
Although we expect the bottom to fall out of the T-Bond market within the next several years, we currently don't have any desire to risk money betting against this market. There are, we think, better uses for our money than betting against the world's most manipulated market at a time when there is no evidence that the prime manipulator (the Fed) has lost its ability to support the market.
Additionally, if we were inclined to take a short position in bonds we wouldn't choose to short the bonds issued by an entity with unlimited access to money. We would, instead, choose to short the bonds of entities that are now cash-strapped or are likely to become cash-strapped during the next major economic downturn. General examples of attractive short-sale candidates are municipal bonds and junk bonds.
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