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Central banks can't ignore this wicked curve ball

In the space of about 48 hours, stock and bond markets, around the world, have become inordinately perplexed by a plunge in global interest rates that is stoking fears of another bout of deflation.

Many individuals are calling B.S. on the notion that deflation, rather than inflation, is our most pressing problem. The average Joe, or Jane, is being socked with higher prices for gasoline; agricultural products from corn to coffee to limes; along with rising tuition and health-care costs.

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They say, "Sure, there's no inflation — if you don't have to drive, buy food, send your kids to college or see the doctor!"

And that's true. But rising prices in the energy and food chains have nothing to do with monetary policy. There are supply disruptions in the energy market, which are the result of geopolitical tensions in the oil producing regions of the world. Grain prices are getting pushed up by droughts from California's Central Valley to Brazil's soybean alley. Meat, meanwhile, is being consumed by a virulent pig disease culling millions of hogs from the herd and pushing up prices for beef, as it becomes a substitute for "the other white meat." Tuition and health care are what they are and require much different fixes than the Federal Reserve can provide.

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This has nothing to do with central bank policy. Indeed, if the Fed were to raise interest rates to quell this type of inflation, consumers would fare even worse as the cost of money would join the rising cost of supply-disrupted goods.

Trouble with the curve

Experienced professional investors, and some enlightened economists, are looking at what they like to call "the term structure of interest rates," more commonly known as the "yield curve." And they are having trouble with the curve … not just in the U.S., but around the world. Long-term interest rates are falling, flattening yield curves everywhere except New Zealand. As history has frequently shown, flattening yield curves imply a couple things: weakening economic growth and/or falling inflation.

If one were to review what are known as "forward rates," 1-year interest rate "forwards" are showing very big bets that short-term rates will be lower four years from now, than they are today … another worrisome indicator. That is most acutely obvious in Europe. Inflation is in danger of falling to zero, or below, as growth slows across the euro zone. Like inflation, deflation can be exported, as can weak growth, or recession. This must have central bankers from Brussels to Beijing to the post-Bernanke Fed increasingly nervous about what to do next.

The trouble with the curve, globally, is that a whiff of deflation is being discounted in many, many bond markets.

Indeed, the Cleveland Federal Reserve published its annual report on Wednesday, pointing to the dangers of inflation that is far too low, here at home.

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The implications of the paper, coming from Sandy Pianalto's bank, a regional Fed president not known to be overly "dovish" on monetary policy, suggests that even skeptics are growing concerned the economy is not fully responding to the Fed's massive, multi-year efforts to get it accelerating toward its full potential, i.e.., full employment AND inflation that tops the Fed's stated target of 2 percent.

The message of the market is becoming more and more clear, particularly if one believes the bond market, rather than the stock market, is the best forward-looking indicator of future economic conditions.

Stocks are getting nervous that the relentless drop in current global interest rates, interest rate forwards, and yield curves everywhere, are reigniting fears of DEFLATION, not inflation.

Time to swing the bat?

The European Central Bank will like bring out its bazooka in June to combat this pernicious problem. I'm beginning to bet that the People's Bank of China, the Bank of Japan, the Bank of England and, maybe even the Fed, will have to reconsider current policies in the face of ominous bond-market indicators.

It's true that bond yields could be falling for structural reasons, as hedge funds cover money-losing short bets on bonds, driving prices up and yields down. Public, and private, pension funds have also loaded up on bonds lately to hedge their equity risk AND match their long-term liabilities, in the face of rapidly rising life expectancies. Foreign central banks, again, intent on devaluing their currencies, may be buying dollars and parking the proceeds in U.S. Treasurys for safekeeping.

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And all that buying comes in the face of an unexpectedly rapid decline in the U.S. budget deficit, reducing bond issuance and creating a certain scarcity value for U.S. debt.

However, falling rates and flattening curves are a GLOBAL phenomenon and it would behoove central bankers, around the world, not to ignore this wicked curve ball being thrown at them. It may, in fact, be time for another big, and coordinated, swing of their bats.

Commentary by Ron Insana, a CNBC and MSNBC contributor and the author of four books on Wall Street. He also delivers a daily podcast, "Insana Insights," and a long-form weekly version, both available on iTunes and at roninsana.com. Follow him on Twitter @rinsana.

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