USA: Why inflation is overrated by the bond market
Inflationary fears are overdone in the bond market. That's why you should buy bonds on dips.
FirecrackersThe headlines of 23rd November were festooned with firecrackers. The inflation-sensitive US Treasury's two year yield climbed to a six-year high of 1.14 per cent; the 10-year Treasury yield lurched by over 10 basis points, the strongest since the Presidential election, and the dollar index motored to a 13-year high.
MiragesThese excited spasms occurred because of headline-grabbing data releases. October's durable goods orders rose an aggregate 4.8 per cent on the face of it; however, if you strip out the transportation sector, it rose by a mere one per cent. - or by a stunning 0.3 per cent year-on-year. October's consumer sentiment index rose to 87.2 on the face of it; however, it actually contracted by an annual 4.5 per cent. And in line with softer consumer sentiment, consumers' inflationary expectations keep tumbling from their high of 4.6 per cent back in April 2011; by this September, they stood at 2.4 per cent. So much for stronger growth fanning inflation!
Stronger dollarNevertheless, what these headline-grabbers did was to propel the dollar to a 13-year high. However, that ever-stronger dollar surely will import ever more deflation to America, - or am I missing something?
Real yield engineSo, despite these benign inflation data, bond yields rose. What was their real motor? The prospect of a blowout in America's $587 bn budget deficit. Trump's tax cuts will cut federal revenues by nearly a trillion dollars a year, whilst his infrastructure plans will cost one trillion dollars over a decade (although my guess is that cost-over-runs at least will double such infrastructure outlays). It is the lethal combination of lower taxes AND higher spending that creates a calamitous budget blowout , and that is what is going on in the market's subconscious. Hence. those climbing bond yields.
Why the Fed must raise ratesNOT to fight inflation, which will remain low for a long time: globalization, the ever-stronger dollar as well as machine-made productivity already have severed that outdated link of strong growth = strong inflation. Indeed, in point two we suggested that consumer sentiment and inflationary expectations are on the soft side, in reality. This implies that it is the budget deficit blowout propelling nominal yields; meanwhile, with low inflation, real yields rise, choking growth. So why must the Fed raise rates? To have weapons ready for the next change in Economic Time®, when the excess demand for goods turns into an excess supply thereof - courtesy of rising real bond yields choking the economy. The Fed wants to start creating its recession-fighting war chest.
Investment implicationThe market's subconscious fear of a budget blowout means a steeper yield curve, so keep buying (healthy) financials and fintechs. And with America's Economic Time® continuing to improve, cheap cyclicals as well as commodity and thus transport plays cannot be the worst bets, either. Indeed, America's railway freight indicators have been improving for some months already!
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