Bond Market Deflation Redux!??!

Summary Thoughts ?

1. The contemporary collapse in the 10-year bond yield is not unprecedented. Indeed, bond yields reacted almost identically during the last recovery at the same time and for many of the same reasons.
2. No doubt deflation risk is enhanced today if for no other reason than global inflation is very close to zero. However, does the bond market reaction at the start of the 2003 recovery and this year reflect a world economy with much higher deflation risk than it has possessed in the past? Or, does it simply reflect an investment culture adjusting to a new “low-inflation world” after decades of persistent and high inflation? In other words, until investors get used to “close-to-zero inflation” (think 1950s, early-1960s culture), perhaps periodic deflation scares will be commonplace?
3. Many have attributed the bond market’s reaction this spring to the ongoing crisis. Doesn’t the collapse in bond yields reflect a “safe-haven” bid amongst governments run amuck, ongoing debt woes, and a less-than-full-functioning banking industry? While there is some truth to this assertion, we would point out a nearly identical bond yield collapse occurred in 2003 without most of today’s crisis concerns.
4. Treasury bond yield volatility will likely stay elevated. In recoveries prior to 2003, the bond market was pricing different potential inflation rates along a continuous spectrum. However, today, as in the 2003 recovery, bond market pricing appears far more bimodal. Bond yield movements reflecting a little higher or lower inflation tend to be far less volatile than a bond market attempting to price “deflation or not.” Essentially, don’t be surprised by scary plunges or surges in the Treasury bond yield.
5. Just as the bond yield collapse in the spring of 2003 helped restart real economic momentum, the bond yield collapse this spring should also assist in improving the current soft patch. Moreover, in addition to lower mortgage rates since late spring, oil prices have declined by $15 to $20 a barrel and the U.S. dollar has retraced about one-third of its advance since late 2009. As in 2003, the deflation scare itself has eliminated many tightening forces and brought renewed stimulus to the recovery.
6. Similar to 2003, the resolution of the contemporary deflation scare and future movement in Treasury bond yields will ultimately be determined not by upcoming inflation reports but rather by whether the economic recovery regains momentum. Many now believe bond yields will remain low and the Fed will be on hold for some time. This may prove correct, but as the 2003 example illustrates, bond yields could surge higher far more quickly and by far more than most now think likely.

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