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The bond market is wrong about inflation

I’ve been making this point for quite some time now, so the purpose of this post is mainly to update the argument with the latest news. I would also like…

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This article was originally published by Califia Beach Pundit

I’ve been making this point for quite some time now, so the purpose of this post is mainly to update the argument with the latest news. I would also like to recommend an article by Thomas Sargent and William Silber that appeared in today’s WSJ: “The Market Is Too Serene About Inflation.” They make essentially the same points I do, but they nicely add some historical context. In the 1980s, it took the bond market a long time to realize that the Fed had successfully brought inflation down from double- to single-digits. What we’re seeing today is similar, only opposite: it’s going to take the bond market a long time to realize that the Fed has allowed inflation to increase significantly. 

And by the way, I was an avid student of inflation and the bond market back in those crazy days of the early- to mid-1980s. I worked for John Rutledge at his consulting firm (the Claremont Economics Institute) during that time, and we were almost alone in our conviction that the combination of Volcker’s monetary policy and Reagan’s tax cuts would result in a huge decline in inflation and interest rates. It took a few years, but we were finally proven right. So I’m not totally surprised to see the bond market making another mistake, even if the circumstances are quite different this time around.

Chart #1
Chart #1 compares the yield on 10-yr Treasuries to the year over year change in the Consumer Price Index. We’ve never seen such a huge difference between the two, and I for one never thought something like this would or could ever happen. Where are the bond market vigilantes when we need them? Those vigilantes are supposed to ensure that interest rates are nearly always as high or higher than the rate of inflation. That’s certainly NOT the case today.
Chart #2
As Chart #2 shows, oil prices have nothing to do with today’s inflation problem. Ex-energy inflation is off the charts. And to judge by the huge difference between today’s inflation and today’s interest rates, the bond market has only just begun to be concerned. 
Chart #3
Chart #3 shows the ex-post real yield on 10-yr Treasuries (i.e., the difference between nominal yields and the rate of inflation according to the CPI). Real yields today are lower than at any time in my lifetime. The last time we saw anything like this was in the inflationary 1970s. 
This is crucially important: when real yields are hugely negative, as they are today, this provides fuel to the inflationary fires, because the return on cash and cash equivalents are so miserable that it destroys the demand to hold cash. And as I’ve explained in many prior posts, its the weak and falling demand for money that is driving today’s inflation. Inflation won’t end until the Fed corrects this problem, and unfortunately, it doesn’t look like they will do that anytime soon. Just today, Powell promised that although the Fed is prepared to raise rates, they will be careful to do so in a fashion that won’t rock the markets or the economy. Sorry, I don’t think the bond market will take a lot of consolation from this sentiment. 
Chart #4
As Chart #4 shows, there is about an 18-month lag between rising rents (about 25% of the CPI is based on what homeowners think they would be paying to rent the house they own) and rising inflation. Given that rents are up only a little less than 4% in the past year, while housing prices nationwide are up about 20%, there is likely a lot of rent inflation that has yet to find its way into the CPI over the next year. 
Chart #5

And it’s not just rent that is going up, as Chart #5 shows. Industrial commodity prices (hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, rosin, and rubber) are up over 25% in the past 12 months, and they now stand at a new, all-time high.

Chart #6
As Chart #6 shows, despite all the evidence of higher inflation, not to mention the runaway growth of the M2 money supply, as I illustrated in Chart #3 of last week’s post, the bond market expects that the CPI will rise on average only about 2.8% per year for the next 5 years.
Keep your seatbelts fashioned, the next few years could be a wild ride.

COVID-19 recommended reading: This article comes from a leading Israeli virologist. The short summary: 1) respiratory viruses cannot be defeated, 2) mass testing is ineffective, 3) natural immunity trumps vaccines, 4) those vaccinated can be and are infectious, 5) Covid death risk is highly concentrated among the elderly and those with several co-morbidities, 6) vaccine side effects are not insignificant, 7) children and young adults should never have been isolated, and 8) masks and lockdowns are ineffective and counter-productive.

I can’t pass up the opportunity to repeat my prediction of April/May 2020: “The shutdown of the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™”

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