“In price is knowledge” was the dictum drummed into me by an editor when I first started writing about finance. The bond market is telling us that the outlook for growth and inflation is the worst it’s been for almost a year. And it’s also suggesting that central banks will fail to meet their key policy objective of pushing inflation back up to 2 percent.
International Monetary Fund Managing Director Christine Lagarde has adopted the phrase “the new mediocre” to describe the current economic backdrop.
“The good news is that the recovery continues; we have growth; we are not in a crisis,” she said on Tuesday. “The not-so-good news is that the recovery remains too slow, too fragile, and risks to its durability are increasing.”
Bond market rates suggest investors see very little prospect of inflation in the coming years, and are therefore willing to put their money in government securities without demanding any return (and in many cases are willing to pay for the privilege by accepting negative rates). The 10-year German yield, for example, just a whisker away from turning negative for the first time ever, is just below 0.1 percent:
The 10-year U.S. Treasury yield, meanwhile, is down to about 1.7 percent from the 2.3 percent level that prevailed when the Federal Reserve raised interest rates in December. That’s odd; long-term borrowing costs should be rising when a central bank is in tightening mode. The Fed says there might be two more rate increases in the pipeline this year; the bond market suggests otherwise.
Higher central bank rates should mean consumer prices are expected to rise; bondholders should therefore demand higher returns to compensate for accelerating inflation eroding the value of their money in the future. But the Federal Reserve Bank of San Francisco reckons market-based gauges of inflation expectations aren’t showing that. “A substantial portion of the decline in these measures reflects a notable downward shift in investors’ medium- and long-term inflation expectations,” the bank said in a report published Monday.
This is important. Former Fed Chairman Ben Bernanke’s 2002 speech “Deflation: Making Sure ‘It’ Doesn’t Happen Here” asserted that “sufficient injections of money will ultimately always reverse a deflation.” But cranking up the printing presses to an unprecedented degree has thus far failed to stoke inflation; and the bond market shows investors don’t expect that to change.
That raises the uncomfortable possibility that the economic textbooks are misleading, the Fed was wrong to raise rates at the end of last year, and that central banks are basically flying blind. Unless and until bond yields start to rise, central banks will continue to miss their inflation targets, and the risk of deflation will remain a threat to the global economy.
Mark Gilbert, a Bloomberg View columnist, is a member of the Bloomberg View editorial board. © 2016, Bloomberg View