US treasuries - deflation predictor or just a bubble?
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Financial Times
Lex: US economy
September 22 2002 20:06
The world's government bond markets have become a battleground for two schools of thought: those who support the bond bubble theory, and followers of the "D-word" - deflation. For the moment, the deflationary camp is gathering strength, egged on by those who have profited in the bond markets from Japan's slump conditions but who now see more reasons for steering clear of JGBs. A statement from the Federal Reserve this week suggesting perils for the US economy ahead would help their cause.
With growth in the third quarter above a 3 per cent annual rate, the Fed will probably remain on hold. But forward-looking indicators are weak, as is the labour market, and the danger of a double-dip has not disappeared. Weak financial markets, anaemic growth outside the US, rising energy prices and the possibility of war in Iraq make for an uncertain environment. But disinflation is different from deflation. Inflation in the US is low but it is still positive and core inflation is actually rising.
Those who believe a bond market bubble is in the making are supported by valuations. Ten-year US Treasury yields are at 40-year lows, and the real rate is more than one percentage point below the 3.6 per cent average of the 1990s. Inflation expectations, measured by the spread between inflation-indexed US bonds and nominal government bonds, have barely budged this year. The drop in yields, therefore, suggests a flight to safety from the equity and corporate bond markets, more than deflation concerns. But how much safety is there in inflation-sensitive assets that take oil prices near $30 a barrel in their stride?
It takes a long time to double your money with yields under 4 per cent. That suggests there is good reason to be cautious about bonds. Moreover, even without war, budget deficits are increasing across the developed world and eventually that will be felt along the yield curve. Meanwhile, the talk of global deflation recalls those "paradigm shifts" peddled in the go-go equities era of the 1990s - and it is clear that much of that was bubble talk.
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