Home > Economy
Deflation or Inflation? Yield Curve Holds the Answer
Typically, a steep yield curve points to inflation. Not so this time, says EWI's Bill Fox.
The Federal Reserve’s balance sheet has exploded, with total reserve bank assets now standing at $2.079 trillion. This same time last year, total assets stood at $1.181 trillion. Inflation? Yes, the balance sheet is significantly inflated -- but is it inflationary?
Not necessarily.
Such a huge reserve certainly has the potential to catalyze inflation (indeed a hyperinflation), but only if the Fed Chairman Bernanke liquidates the assets that make up the reserve accounts. Simply put, there is no inflation if the Federal Reserve refuses to turn those assets into cash and dump that cash into the economy.
Consumer-driven inflation is not there. Consumers have to have cash (or credit) in hand to create demand upon products, services and raw materials -- and thus drive up their prices. When rising home prices and easy-to-get credit cards financed consumer purchases, demand was strong. But now the housing equity is gone, millions are out of work, average wages are stagnant and lending standards have returned to the world of reality. "Inflationary pressures"? Not here.
What about the U.S. government's $300 billion in bond purchases and $1 trillion in agency debt purchases -- i.e., monetization of debt? Well, when it comes to the total balance of assets sold and bought by Foreign Central Banks and Sovereign Wealth Funds, we are not seeing is a run on Treasuries -- we are seeing as a shift in risk tolerance. The Saudis, Russians and Chinese, who had tens of billions happily invested in U.S. agency paper, were not so happy to see Fannie Mae and Freddie Mac go the way of de-facto nationalization. But did they sell their dollar portfolios and look for euro-denominated chateaus in France? No -- they shifted to shorter-dated U.S. Treasuries. The Chinese and the Russians dumped their GSE paper to the Fed, took those dollars and re-invested in explicitly guaranteed U.S. government paper. Therefore, total dollar pool remains essentially unchanged. No inflation here.
This essay originally appeared in the June 5 forecast for U.S. Treasury bonds inside Bill Fox’s intensive Interest Rates Specialty Service. What are EWI's Specialty Services?
What about the Fed's $300 billion in "quantitative-easing" Treasury purchases? Not significant enough. While the Fed is announcing its steady, small purchases, the yield on the 10yr note continues to rise. The purchases are not large enough to be monetization of the debt and are therefore are not inflationary.
Finally, my subscribers point to my presently bearish Elliott wave count for the 30-year U.S. Treasury bond. How can I be bearish unless we are headed into inflation? In turn, I point to the near-vertical yield curve of late. Yes, in deflation, you would expect a relatively flat curve, but it's been steepening not because of inflationary pressures. Those who view it as a green shoot for recovery and future inflation do not understand WHY the curve has steepened so much and so fast. This country's recent fiscal policies have necessitated a massive debt, and the resulting Treasury sales are simply overwhelming the bond market. What should be a flat curve -- fitting the deflationary cycle we are in -- is artificially steep due to the lack of demand for long-dated Treasuries at auction. There has been no demand from foreigners for the long bond at 4% or 4.5%. How high will the yield need to go before demand returns? Who knows, but it will be substantially higher than current levels.
Bottom line, while the Federal Reserve certainly retains the fuel for inflation, there are no sign that inflation is at hand -- in fact, all signs point to continuing deflation. It’s all there to see on the U.S. yield curve.
Bill Fox has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional traders spread around the globe.