Mini-Panic Over Inflation After Trump’s Election Victory

We have witnessed truly astonishing short term market conniptions following the Donald Trump’s election victory. In this post we want to focus on one aspect that seems to be exercising people quite a bit at present, namely the recent surge in  inflation expectations reflected in the markets. Will we have to get those WIN buttons out again?

 

winA 1970s “whip inflation now” button. The only thing that was actually needed to “whip inflation” was for the Federal Reserve to stop printing money in ever greater quantities (or to stop supporting rapid money creation by the commercial banking system). It started doing so about 2 years before Mr. Paul Volcker took the helm – true money supply growth began to slow down considerably. Volcker then exacerbated this slowdown and briefly even pushed broad true money supply growth into negative territory. By that time, the decline in price inflation had already gotten underway and the public’s inflationary psychology soon underwent a sea change – right on the eve of one of the strongest increases in manufacturing productivity in modern history.

 

As far as we understand it, the current narrative approximately consists of the following:

Because Trump unexpectedly helped the otherwise hapless Party of the Republican Fearful to actually achieve a clean sweep in the election, it is widely assumed that he will be able to push through most of his agenda. Of course election promises cannot always be fulfilled – even if the president is willing.

The market action since the election reflects expectations that US government spending, budget deficits and public debt are likely to soar, presumably based on the idea that the proposed combination of large-scale infrastructure spending and tax cuts will squeeze the federal budget from two sides. Given Trump’s stance on international trade, there is likely also some trepidation regarding future import prices.

Moreover, China is high on the list of Trump’s targets with respect to trade. A significant decline in China’s trade surplus with the US would put renewed pressure on its foreign exchange reserves. China remains the largest US creditor though, and has already turned into a seller of treasury securities. Although we believe the importance of this fact is overestimated, the prospect of China potentially increasing its selling of treasuries further may well be coloring market perceptions to some extent.

 

1-tyxTreasury bond yields were already in an uptrend prior to the election, which has accelerated rather noticeably since then – click to enlarge.

 

Most indicators of market-based inflation expectations were already in an uptrend well before the election. Similar to the trend in bond yields, this has now accelerated. Note that the term “inflation expectations” in this context strictly refers to expectations regarding the future rate of change in CPI. It does not refer to actual inflation, i.e., the expansion of the money supply.

Below are several charts illustrating the situation:

 

2-five-year-breakeven-rateThe five year breakeven inflation rate has moved back to levels last seen in the summer of 2015. This may not seem particularly noteworthy at first glance, but the current level of 167 basis points is 80% higher than the low of 93 basis points recorded in February of this year – click to enlarge.

 

Along similar lines, the 5 year/ 5 year forward inflation rate (which reflects 5 year inflation expectations from a point in time 5 years in the future) has jumped quite a bit as well:

 

3-five-five-forward-rateThe 5 year/ 5 year forward inflation expectation rate has also trended up since early 2016. The move circled in red represents the “Trump jump” – click to enlarge.

 

Another perspective is provided by the TIP/TLT ratio. This ratio compares the prices of ETFs tracking long term inflation-protected securities and “normal” long term treasuries. A rising ratio means that TIPs are outperforming treasuries in terms of price, which means the yield differential between these securities is widening as well (i.e., treasury yields are increasing relative to TIPs yields).

This is typically the result of rising inflation expectations, as TIPs are specifically designed to protect investors against an increase in future CPI growth rates. To be sure, the rise in the ratio is a fairly recent phenomenon as well – it was mired in a strong downtrend from early 2012 until July of this year (incidentally it has diverged from other indicators of inflation expectations in the process, by making a lower low in the summer in the wake of the Brexit referendum).

 

4-tip-tlt-ratioThe ratio of TIP to TLT is a useful proxy for long term inflation expectations. It has recently increased sharply as well – click to enlarge.

 

The Yield Curve and Recession Probabilities

It remains of course uncertain whether the expected increase in price inflation on account of Trump’s policies will actually materialize. As noted above, much will depend on the extent to which he will be able and/or willing to implement his proposals. Let us hypothetically assume though that the Trump presidency will actually serve as a “trigger” for rising consumer price inflation.

What remains to be considered in that case is whether the Fed will remain “behind the curve” or not. The Fed would certainly love to tighten policy, mainly in order to have some leeway to cut rates again when the next recession begins. Let us briefly look at the yield curve in this context, or rather a specific part of it, namely the  difference between 10 year and 2 year treasury note yields.

 

5-yied-curve-10-minus-2The yield curve has begun to steepen rather noticeably after flattening quite a bit from its early 2011 post-crisis peak to the lows made this year – click to enlarge.

 

The standard view is that a steepening yield curve is “good for the economy”. This  is actually not quite correct. Let us consider what a steepening yield curve actually means. Steepening can happen in two ways: one is that the central bank is cutting administered interest rates and short term rates decline faster than long term ones.

Long term rates usually remain comparatively higher in this scenario, because long term inflation expectations tend to increase when the central bank loosens monetary policy. The other possibility is that inflation expectations rise for other reasons. In short, a steepening yield curve is primarily another proxy for an increase in long term inflation expectations.

In a certain sense the notion that a steepening curve is “good for the economy” is not entirely wrong, as monetary pumping by the Fed will tend to set the boom portion of the boom-bust cycle into motion – albeit with a noticeable lag. Even though the economy tends to consume real wealth during boom periods driven by credit expansion, these periods are of course associated with an increase in economic activity and positive aggregate economic data.

Obviously thougfh, large rate cuts are usually not implemented unless the Fed wants to counter a beginning recession. The empirical record shows that as a boom progresses, the yield curve will increasingly flatten, often until it inverts. Once the trend clearly reverses to steepening again, a recession signal is actually given.

So initially, the steepening of the yield curve is actually “bad” for the economy, at least from a mainstream perspective. Of course, in the wake of the distortions wrought by a boom, a reorganization of the economy’s production structure and the associated liquidation of malinvested capital is in reality not “bad”, but rather  “badly needed”. It is the only way to restore the economy to a sound  footing.

This healing process will obviously involve a bust though. It takes time for the economy to become realigned with the proper balance between production, consumption and savings again that reflects reality rather than the Potemkin village of the artificial credit-induced boom. During bust periods, we will as a rule see a rapid steepening of the yield curve (a side note: this is particularly relevant in a central bank-administered fiat money system).

 

6-yield-curve-recession-signalThis long term chart of the 10 year minus 2 year treasury yield spread illustrates the point made above. During boom periods, the curve tends to flatten. Usually it will eventually invert and not too long thereafter begin to steepen again. This trend change toward steepening actually constitutes a recession warning – recessions usually tend to begin with a lag of 6 to 18 months following the reversal of the trend. The yield curve then continues to steepen throughout the official recession period and beyond (note that the double-dip recession under Volcker constitutes an exception to the rule, as it involved no such time lag. This was mainly due to the Fed maintaining a very tight policy stance even after the start of the recession) – click to enlarge.

 

Obviously, the above chart immediately raises an important question: should we not see an inversion of the yield curve prior to the reversion to the steepening trend that gives us the heads-up  that a recession 8is not very far offf? This is actually an example that illustrates that one must always keep contingent circumstances in mind when interpreting historical economic data.

We have actually discussed this question in a previous article (see “The Yield Curve and Recessions” for details). Japan’s experience suggests that once the central bank implements zero interest policy (ZIRP), yield curve inversions no longer occur prior to recessions (see also this chart). In fact, the last time Japan has seen an inverted yield curve was prior to the bubble peak of the Nikkei in late 1989. There have been six recessions in Japan since then – and five of them were not preceded by yield curve inversions.

 

Conclusion

The recent reversal of the yield curve from flattening to steepening may well constitute a recession warning, even if it is not conclusive yet. Considering the weakness of the post GFC economic recovery, the poor performance of the manufacturing sector and the downturn in private investment we have discussed in these pages on previous occasions, this potential warning should definitely not be dismissed though.

What is likely to happen if the markets are correct in anticipating an upturn in consumer price inflation and an economic downturn strikes concurrently? In that case we think one should definitely expect the Fed to remain “behind the curve” and negative real interest to persist as a result. After all, the current economic orthodoxy once again appears to consider stagflation an impossibility.

This is to say that a rise in consumer price inflation during an economic downturn would likely be regarded as a strictly temporary phenomenon, giving the central bank a reason to maintain loose monetary policy. As a side note: we are never trying to suggest “better plans” for the central planners at agencies like the Fed. We are merely trying to forecast their likely reactions to certain developments based on what we know about their views and actions to date.

This would essentially be the worst possible outcome for the economy and the financial markets. One factor that may indicate that it won’t happen just yet is the  broad consensus that has rapidly formed regarding the inflation outlook (see Mish’s discussion of this point here). Still, we believe for a number of reasons that the probability of a return of stagflation has indeed increased in recent years. It is a topic we are definitely going to revisit.

 

Charts by: StockCharts, St. Louis Federal Reserve Research

 

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

2 Responses to “Inflation Expectations Rise Sharply”

  • The Fed DOES NOT PRINT MONEY, stop regurgitating that lie.

    100% of all inflation, is debt based credit and it is generated by the banks and Wall Street, not the Fed. The Fed is little more than their whipping boy beard, providing cover and excuses, after the fact.

  • Bam_Man:

    I am looking forward to seeing every one of those multiple, huge gaps being filled on the charts of $TNX an $TYX.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Biggest Stock Market Crashes Tend to Happen in October
      October is the Most Dangerous Month The prospect of steep market declines worries investors – and the month of October has a particularly bad reputation in this respect.   Bad juju month: Statistically, October is actually not the worst month on average – but it is home to several of history's most memorable crashes, including the largest ever one-day decline on Wall Street. A few things worth noting about 1987: 1. the crash did not presage a recession. 2. its...
  • Canada: Risks of a Parliamentary Democracy
      A Vulnerable System Parliamentary democracy is vulnerable to the extremely dangerous possibility that someone with very little voter support can rise to the top layer of government. All one apparently has to do is to be enough of a populist to get elected by ghetto dwellers.   Economist and philosopher Hans-Hermann Hoppe dissects democracy in his book Democracy, the God that Failed, which shines a light on the system's grave deficiencies with respect to guarding liberty. As...
  • Federal Reserve President Kashkari’s Masterful Distractions
      The True Believer How is it that seemingly intelligent people, of apparent sound mind and rational thought, can stray so far off the beam?  How come there are certain professions that reward their practitioners for their failures? The central banking and monetary policy vocation rings the bell on both accounts.  Today we offer a brief case study in this regard.   Minneapolis Fed president Neel Kashkari attacking a block of wood with great zeal. [PT] Photo credit: Linda Davidson...
  • Thoughtful Disagreement with Ted Butler
      Too Big to Fail?   Dear Mr. Butler, in your article of 2 October, entitled Thoughtful Disagreement, you say:   “Someone will come up with the thoughtful disagreement that makes the body of my premise invalid or the price of silver will validate the premise by exploding.”   Ted Butler – we first became aware of Mr. Butler in 1998, and as far as we know, he has been making the bullish case for silver ever since. Back in the late 90s this was actually a...
  • Donald Trump: Warmonger-in-Chief
      Cryptic Pronouncements If a world conflagration, God forbid, should break out during the Trump Administration, its genesis will not be too hard to discover: the thin-skinned, immature, shallow, doofus who currently resides in the Oval Office!   The commander-in-chief - a potential source of radiation?   This past week, the Donald has continued his bellicose talk with both veiled and explicit threats against purported American adversaries throughout the world.  In...
  • Precious Metals Supply and Demand Report
      Fat-Boy Waves The prices of the metals dropped $17 and $0.35, and the gold-silver ratio rose to 77.  A look at the chart of either metal shows that a downtrend in prices (i.e. uptrend in the dollar) that began in mid-April reversed in mid-July. Then the prices began rising (i.e. dollar began falling). But that move ended September 8.   Stars of the most popular global market sitcoms, widely suspected of being “gold wave-makers”. From left to right: Auntie Janet...
  • The Donald Can’t Stop It
      Divine Powers The Dow’s march onward and upward toward 30,000 continues without a pause.  New all-time highs are notched practically every day.  Despite Thursday’s 31-point pullback, the Dow is up over 15.5 percent year-to-date.  What a remarkable time to be alive.   The DJIA keeps surging... but it is running on fumes (US money supply growth is disappearing rapidly). The president loves this and has decided to “own” the market by gushing about its record run. During...
  • 1987, 1997, 2007... Just How Crash-Prone are Years Ending in 7?
      Bad Reputation Years ending in 7, such as the current year 2017, have a bad reputation among stock market participants. Large price declines tend to occur quite frequently in these years.   Sliding down the steep slope of the cursed year. [PT]   Just think of 1987, the year in which the largest one-day decline in the US stock market in history took place:  the Dow Jones Industrial Average plunged by 22.61 percent in a single trading day. Or recall the year 2007,...
  • Stocks Up and Yields Down – Precious Metals Supply & Demand
      Where the Good Things Go Many gold bugs make an implicit assumption. Gold is good, therefore it will go up. This is tempting but wrong (ignoring that gold does not go anywhere, it’s the dollar that goes down). One error is in thinking that now you have discovered a truth, everyone else will see it quickly. And there is a subtler error. The error is to think good things must go up. Sometimes they do, but why?   Since putting in a secular low at the turn of the millennium,...
  • The 2017 Incrementum Gold Chart Book
      A Big Reference Chart Collection Our friends at Incrementum have created a special treat for gold aficionados, based on the 2017 “In Gold We Trust Report”. Not everybody has the time to read a 160 page report, even if it would be quite worthwhile to do so. As we always mention when it is published, it is a highly useful reference work, even if one doesn't get around to reading all of it (and selective reading is always possible, aided by the table of contents at the...
  • The Falling Productivity of Debt
      Discounting the Present Value of Future Income Last week, we discussed the ongoing fall of dividend, and especially earnings, yields. This Report is not a stock letter, and we make no stock market predictions. We talk about this phenomenon to make a different point. The discount rate has fallen to a very low level indeed.   We add this chart to provide a slightly different perspective to the discussion that follows below (and the question raised at the end of the article)....
  • Precious Metals Supply and Demand
      Fundamental Developments The prices of the metals shot up last week, by $28 and $0.57.   Heavy metals became pricier last week, but we should point out that the stocks of gold and silver miners barely responded to this rally in the metals, which very often (not always, but a very large percentage of the time) is a sign that the rally is unlikely to continue or hold in the short term. [PT]   Last week, we said:   “One way to think of these moves is...

Support Acting Man

Top10BestPro
j9TJzzN

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com