A Long Term Look At Inflation Fears

Those of us who experienced and were traumatized by the massive double digit inflation shocks of the 1970's and 1980's still remember them very well.  Even after inflation dipped to around 2-3% and stayed there starting around 1990, we still feared its comeback.  This fear could best be seen in the yield of the 10 year Treasury bond, which stayed well above annual inflation for another 20 years.  It took almost an entire generation for that fear to dissipate and for bond yields to come way down - Chart 1.

Chart 1 - Comparison Between 10 Year Treasury and PCE Inflation

But look at it now: The spread between bond yields and inflation has disappeared, and even turned negative. The situation is even more eye-popping in Europe where Germany sports negative rates and even perennial bankrupts can borrow for 10 years or longer at under 1%.

Ten years after the Great Credit Bubble and the massive world-wide government monetary interventions which followed, inflationary fears are completely gone;  in fact they has been replaced by a personal and, even worse, institutional indifference towards inflation.  Central banks, by definition the very keepers of monetary rectitude, are now the worst offenders as they keep printing trillions to "boost the economy".

(I'm going to mention only in passing that the limits to growth nowadays have absolutely nothing to do with credit and/or the amount of money in circulation, they are much more fundamental, eg climate change)

 Looking into the future, inflation in the US is expected to be around 2-2.5%, but 10 year Treasury yields are only at 1.40%, even if sharply up from their lows last year - Chart 2. 

Chart 2 - Comparison Between 10 Year Treasury and  5-Year Forward Inflation Expectation

Despite their recent rise, yields are still significantly below inflation expectations, a situation that can best be described as abnormal.  Now, if the market was left to itself you can be certain that rates would be well over 2% and probably closer to 3%.  But, the Fed (and the ECB) is in the market daily, buying everything that moves in a an attempt to keep rates low.  IMHO, that's ultimately a fool's errand, the bond market is simply too huge to manipulate once it gets convinced that inflation is on the rise.

To make matters worse, the money the Fed prints daily (and more is coming!) is creating the largest stock market bubble in history.  Share valuations are - to put it mildly - insane, with price to sales ratios at heroic levels - Chart 3.

  Chart 3 - S&P 500 Price to Sales Ratio At Nosebleed Level

We are living through very interesting times, an unprecedented nexus where Treasury, Fed, market operators/manipulators and small-time, clueless plungers are all fearlessly aligned against rationality. By comparison, Flat Earthers are logical..

It won't end well.