Soaring inflation creates headwind for long bonds

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I have alerted readers in two recent posts (US Long Bonds in Injury Time and Watch the Stock/Bond Ratio) that I was of the opinion that US long-dated bonds were topping out.

The following chart of the US 10-year Treasury Note yield indicates that we have now arrived at an important point of resolve regarding an upward break of both the trendline and 50-day moving average:

16-april-4.jpg

Source: StockCharts.com

Whereas safe-haven buying has driven long bond yields sharply lower ever since the advent of the sub-prime crisis, investors now seem to have started focusing more strongly on the inflation outlook rather than on economic growth considerations. And rightly so, as the latest batch of statistics points to rising inflation around the globe.

It would appear that financial markets currently face three potential price pressures, as succinctly summarized by GaveKal:

“1. Soaring food and energy prices
Whatever the reason may be, elevated food and energy prices are becoming a real concern. The price of rice, for example, has simply gone parabolic this year. In Bangkok, white rice is now up +120% YTD.

Meanwhile, oil reached yet another record high yesterday, closing at US$113.8/barrel. On that topic, we note with some concern that … world expenditure on oil, as a percentage of global GDP, is back to 7% – a level not seen since 1980. Given the severity of the global recession that followed in the early 80s, this data point does not instil confidence.

16-april-1.jpg

2. Rising export prices from Asia
According to BLS data from March, import prices from China are now rising +4% YoY, highlighting a rise from negative growth only one year ago. Moreover, US producer prices are now rising faster than expected, up +6.9% in YoY in March. These are all signs that we are indeed witnessing a significant shift in the terms of trade between the East and the West, and all of this does not bode well for the US consumer, whose spending is already waning.

16-april-2.jpg

3. Excessive monetary easing by central banks
Two months ago, the Fed was under great pressure to ‘get back on the curve’. With a couple of significant rate cuts and a series of other easing measures in mid-March, some say the concern is now that the Fed is easing too much – and that it could now be creating the next bubble, this time in commodities. However, we are hesitant to criticize the Fed in this respect when M1 growth remains non-existent (as it has been for the last couple of years) and monetary base growth is at a 7-year low.”

16-april-3.jpg

Although long bond yields may not yet skyrocket given the poor economic outlook, it seems prudent not to be exposed to an investment that will by definition lock in an unattractive total return of 3.7% over the next 10 years. As a matter of fact, it may not be a bad proposition to buy a few out-of-the-money put options on long-dated bonds.

 

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6 comments to Soaring inflation creates headwind for long bonds

  • [...] Prieur du Plessis says inflation issues are starting to affect the outlook in the bond market. “Whereas safe-haven buying has driven long bond yields sharply lower ever since the advent of the sub-prime crisis, investors now seem to have started focusing more strongly on the inflation outlook rather than on economic growth considerations. And rightly so, as the latest batch of statistics points to rising inflation around the globe,” he writes. [...]

  • richard warren

    right on!
    Fortunately, I saw this coming a couple months ago, and consequently, began liquidating my bond (not TIPS) positions in favor of low yielding money markets (better to settle for low interest than large losses).

  • jj

    While M3 and MZM have exploded , people forget that Velocity of money supply is at a 60-year low ….why is there a disconnect there ?

  • Frank Wordick

    Thanks for this, Prieur. You pretty well covered the T-bond situation. I might mention that food prices rose 20% in the last three months in China. One wonders how much longer the Chinese government is going to allow breakneck development growth to continue. We may be finally approaching the demise of the commodities boom and especially gigantic oil prices. The other thing is that M2 and M3 over which the Fed evidently has little to no influence have been growing fairly strongly — that is if memory serves me correctly. These measures apparently are controlled by banks, e.g. importing Eurodollars. I wonder if these latter measures at least one of which the Fed has decided to no longer compute have any impact on the inflation outlook.

  • David Wallace

    If money is starting to come out of bonds where is it going to go? Will it add to the $3.5 trillion in money markets? Gold? Gold shares?

  • Ariel Wolfe

    Does this sentiment also apply to inflation-linked bonds? They have been down the past month or so, and I’m considering selling, but others have urged me to continue to hold as stagflation is a good environment in which to own TIPS. Can anyone help with this confusion?

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