Bonding with the Bond (Rosenberg)

This is a guest contribution by David Rosenberg, Gluskin Sheff.

Call it a pre-Canada Day barbeque with Dave. There is no Breakfast tomorrow so we thought we’d put out a primer on our current thoughts.

The U.S. long bond yield is edging lower with each and every passing day, and now stands below 3.90%. At the same time, we cannot help but notice the huge gap that still exists between 10s and 30s — nearly 100 basis points. There is tremendous potential for a narrowing in this spread, as there is between the 115 basis point gap between 5s and 10s. The entire yield curve is primed for a bull flattener. And, if we are right on the deflation theme, then long duration on high-quality bonds would seem to make some sense. (There is still potential for lesser grade corporates, but the higher the risk, the lower the duration in the current economic backdrop.)

Still, we all tend to focus on the 10-year note given its deep liquidity and the fact that the mortgage market is priced off it. We bring this up because the Cleveland Fed just published a report on Estimates of Inflation Expectations, and based on our reading of where their numbers are on inflation expectations, the inflation risk premium and real rates, we stand a very good chance of seeing the yield on the 10-year note ultimately grind down to 1.9%. So, the answer is yes, we are likely to see new lows in U.S. Treasury yields occur across the curve before this bull market is over (after all, we are already there out to the two-year segment of the curve). Moreover, note that the 1.9% level would actually mark a fair-value yield — if this truly morphs into a bubble, we could be talking about market rates heading even lower than that.

We have said time and again that the most important driver of bond yields is the direction of inflation. This is twice as important as fiscal policy, as an aside. U.S. core inflation (which excludes food and energy) is already near-record low rates — at 0.9% year-over-year, it is just 20bps from the all-time low of 0.7% seen in March 1961. Could the core inflation rate head lower?

We took a closer look at what’s behind the 0.9% core rate. Core goods (commodities excluding food and energy) is running at 1.1% while core services (services less energy) is running at 0.9%. It struck us that there is a very real chance that the core goods component could indeed be headed lower given that commodity prices have rolled over, and as we see the lagged impact of the strength in the U.S. dollar dampen import costs.

In fact, if you go back to that “deflationary” period of 2003, core goods were actually deflating at a 2.6% rate, but core services were running at +2.6% and hence the overall core rate of inflation was still in positive terrain, at +1.1%. If we assume that core goods could once again bottom at around this rate, then simple math tells us that core inflation could slip below zero, to 0.1% year-over-year, which would be the first time on record (since the Bureau of Labor Statistics started publishing core CPI statistics in 1957) that core inflation is deflating.

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