If we have learned anything from this period in economic and financial history, it should have been to take great care when using or expecting past correlations as valid. There are innumerable examples where that dynamic shift applies, but it seems especially relevant at the end of April 2015. The amount of space and pixels dedicated to the idea that the bond market is about to undergo a sustained selloff has been a dominant theme since the first utterance of taper. But rather than follow those orthodox “instructions”, the bond market has been doing much the opposite since November 20, 2013.
The latest attempt at a redo is with inflation breakevens. Concurrent with oil prices, breakevens have risen substantially in the past few weeks. That has been used as evidence that the entire bond market is about to let go its obstinate contradictions and finally embrace the FOMC narrative. The title to this BloombergBusiness article is revealing in that regard.
But perhaps just as important is the bond market’s changing perception of the Federal Reserve. Instead of worrying about how the Fed’s zeal to roll back its policy of holding interest rates near zero might choke off growth, bond traders are now confident the central bank will let the economy regain the momentum it lost with oil’s plunge before raising borrowing costs.
“We’ve been through the negative impact” of oil, said James Evans, a New York-based money manager at Brown Brothers Harriman & Co., which oversees about $15 billion. “And the Fed is still going to be very cautious about raising rates. The foundation is there for higher inflation.”
If there were such a broad bond market shift, it would, of course, be directly observable broadly across the bond market. Interestingly, none is currently available to bolster the “inflation-fear” interpretation. In fact, the bond market is behaving as consistently languishing for all of 2015 now. There is neither a shift in nominal rates nor a rapid and steepening yield curve for which you would expect a “spooked” embodiment.
There is again this curious stability down around the lowest points, without much hint of retracing much more than a small part of the most recent “safety” and liquidity bid. If these market’s were “spooked” they wouldn’t look much like this at all – the yield curve woulld be steepening, and nominal rates rising, as fast as breakevens. This problem of interpretation seems to reside with what breakevens may mean in the ZIRP/QE world post-crisis. Mainstream attention seems to suggest inflation breakevens assert inflation expectations without qualification, when the history of them these past few years does not align with that explanation. One hint for that is the inflection most recently in breakevens themselves, which bottomed out on January 14 of this year.
There was no shift in the “dollar” at the point, and crude prices remained low and even fell significantly further all the way to March 18. So if there is an explanation for the change in breakevens, it it does not lie within “inflation.” Instead, the very next day, January 15, points to this dichotomy, namely that was the day the Swiss National Bank broke its euro peg (for “dollar” reasons).
In this sense, I think Paul Krugman is correct even if I vehemently disagree about what that means and what to do for economic correction. He was almost uncontrollably dismissive of the SNB’s concerns not so much for the sake of the Swiss or Europe, but rather because he felt that it would reduce the credibility of central banks everywhere. And thus, I think, we have the framework in which to understand what is taking place in breakevens – when the SNB broke the peg they introduced the believable idea that central banks would relent.
In the case of the US version of the system, that meant the FOMC’s seemingly suicidal course toward ending ZIRP. “Markets” have been for months, even going back to November 20, 2013, proclaiming that raising interest rates was tantamount to disaster. “Inflation” breakevens themselves became accustomed to that sentiment, first failing to recognize the so-called unimpeachable recovery of 2014 and then openly defying it in tandem with the “dollar’s” rise.
What inflation breakevens suggest, then, is not inflation at all but rather this tendency to go between new policy intrusions and the inevitable result when they are removed. TIPS securities themselves are thus acting as hedging instruments, along with other securities, against changes not in general economic prices but rather in what the FOMC will do or will not do.
The entire track of inflation breakevens since 2009 resembles almost nothing of actual “inflation” over that period. The major ups and downs do, however, align very, very closely to the various QE’s and especially their ends. In that sense, credit markets are incredibly damning about the efficacy of QE and monetary policy. TIPS hedging goes between acting in concert for expectations of only more monetary policy (not actual changes in the CPI) and then a sustained disinterest thereafter its conclusion, as if there were nothing gained in the actual economy to be hedged against.
In one important sense, however, 2015 so far is very different from past episode where QE has ended and rumors of its renewal started again. As I noted above, breakevens began suggesting that the FOMC would back off way back in January, which seems to be the coalesced read of the broader markets (even the Bloomberg article). However, these broader credit markets, including funding markets, no longer view such a change of heart as cause for steepening/repricing a more optimistic outlook. In other words, in contrast to the past, even though breakevens suggest a serious shift in policy, bond markets no longer seem to believe that is meaningful with regard to the real economy or even deeply embedded financial risk perceptions.
The Fed may actually be changing its mind, the opposite of what Bloomberg suggests, as policy hedging in TIPS seems to bear out, but the bond market apparently doesn’t seem to think that is much of a distinction anymore. Either that means they are too late, or that perceptions about what QE does have evolved with the read on actual circumstances.