Investors in Treasury bills are paying for the privilege of lending to the US government as investment safety is given top priority
There is a premium on safety these days. Consumers want to be safe. They run out to buy duct tape and plastic sheeting to protect against biological and chemical attacks, only to learn they might suffocate in their hermetically sealed safe rooms.
Investors are so interested in safety they are willing to accept a negative real return. With US consumer price inflation running at 2.6%, energy counts. Treasury bills and notes out to five years reward the investor with nothing.
Actually, it is less than nothing. Investors pay for the privilege of lending to the US government, which, even though it is widely despised, still needs to attract some $1.4bn a day from abroad.
That the biggest debtor in the world offers negative real yields has all the makings of a vicious circle, according to Tim Bond, chief global strategist at Barclays Capital Group in London.
'Foreign lenders, unable to secure a reasonable real return for lending in dollars, demand a cheaper dollar,' Bond says. 'The cheaper dollar increases actual inflation and inflation expectations, reducing real returns further.'
As higher inflation expectations get priced into nominal yields that continue to fall, real rates decline, leading to further dollar depreciation, higher inflation expectations, lower real returns and so on. While that may sound alarmist, part of Bond's scenario is already playing out ' the dollar is falling, inflation expectations are rising and real yields are declining.
Inflation expectations have been drifting up for three months, reflected in a wider spread, or breakeven rate, between nominal bonds and inflation-indexed Treasuries (Tips). The spread between the 3.375% Tips of January 2007, which has rallied 120 basis points since the start of December to a yield of 0.6%, and a nominal Treasury note of the same maturity has widened by 52 basis points.
Some of the increase reflects a typical early-year seasonal pattern, according to Gemma Wright, director of market strategy at Barclays Capital Group.
'There is a bias to how breakevens behave,' Wright says. 'People buy Tips early in the year to get the incremental inflation carry.'
While the consumer price index (CPI) is adjusted for seasonal price increases, the CPI used to calculate the daily inflation accretion on Tips is not. Because higher inflation in the first five months of the year is not adjusted away in the index used for Tips, they typically outperform in the first five months of the year, Wright says. 'The inflation accretion helps offset any losses in the market,' she notes.
The fact breakevens have widened by 35 basis points more than the average for December, January and February 'suggests something else is going on,' Wright says.
Concerns about higher inflation are few these days. The US economy is facing an oil shock, a possible war, terrorist threats and slumping consumer and business confidence, so who in his right mind is worried about inflation?
No one will deny the Fed has succeeded in engineering price stability, that Nirvana state in which inflation is no longer a consideration in business and consumer decision-making. As a practical matter, price stability equates with inflation of 2% or lower.
The assumption is that the Fed's work is done, as if the central bank can ever declare the battle against inflation won. The great deflation of the Great Depression ' real deflation, not the goods deflation of today ' gave way to post-war inflation.
The Federal Reserve, which was not independent in those days, pegged long-term interest rates to help the war effort. Measured inflation was comparatively modest during World War II, with the prices of 85% of all consumer goods and services fixed by the Office of Price Administration.
Once those controls were lifted in mid-1946, the CPI soared, rising 18% that year, the biggest one-year increase in history.
'Just because we have gotten inflation down does not mean it can't come back,' says Bob Laurent, professor of economics at the Illinois Institute of Technology's Stuart School of Business.
Having skirted deflation, all central banks are 'likely to target higher inflation than in the past,' he says. 'They need a cushion in case of another negative shock.'
The Federal Reserve will clearly err on the side of being too accommodative for too long, given the protracted period of below-trend growth and inflation that dipped to 1.1%, as measured by the CPI.
Bloomberg New York newsroom
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