“The sky is falling; the sky is falling!” Substitute “bond prices” for “sky” and you’ll have a sense of the mood in the fixed-income market the last few months.
I won’t diminish the potential bearish impact the swelling U.S. budget deficit will have on the bond market as supply surges in the months and years to come.
But we don’t know how much it will affect the market if there is no accompanying increase in inflation and gross domestic product. Still, that hasn’t stopped people from making too much of bearish data, while ignoring a soft underbelly that challenges the bearish narratives. That’s what I’m about to do.
(Related: Everyone Has Forgotten the Downside to Debt)
Certainly, five increases in the federal funds rate since December 2015 and the doubling in 10-year Treasury note yields since mid-2016 would constitute a bear market by any measure, but what I suspect is coming is more of a teddy-bear market than a grizzly bear, at least based on recent statistics and hyperbolic stories throughout the press.
First, I’ve read, reread and read yet again articles about the deficit exploding. We knew of that danger well before the tax plan was enacted into law in December. Each report pretty much rehashes the same statistics in an attempt to explain the rise in volatility and interest rates. In reality, few dollars have been added to the deficit projections. When old news is rehashed as new information it can arouse emotions without adding more to the fundamental picture.
Second, there’s the selective use of data events, which I have also used to my advantage. Take the consumer price index. A greater-than-expected increase on Wednesday provoked a sharp selloff in the bond market and was followed by press reports of inflation coming back and, along with a weak retail sales report that same day, led to the term “stagflation” being thrown around.
But here’s the thing: January is a notoriously bad month for inflation. On average, it shows the second-highest monthly increase over the course of a given year and is the highest for the core figure, which excludes food and energy. This particular January had very cold conditions, which may help explain that two of the largest contributors to the gain in the CPI were energy and apparel. In other words, from an historical perspective we can expect month-over-month gains to ease.