I've had to update the behavior of the Treasury's inflation-protected securities three times this week because the movement there has been largeand because the new underlying message carries implications for all asset classes.
This was apparent Thursday in the behavior of markets worldwide following news that S&P had lowered its outlook on England's sovereign debt. The move put focus on nations with growing debt burdens, including the United States.
Investors normally associate sovereign debt burdens with growing inflation risks, especially when the debts are being monetized by expansionary monetary policies. Inflation risks are also wrought by the inefficient allocation of capital that results from money moving from the private sector to the government sector. There is also of course the idea that deficit spending will boost inflation pressures on their own, although the weak level of demand makes it unlikely that government spending will bring economic activity to levels that boost inflation.
Today, the amount of inflation embedded in the Treasury's inflation-protected securities is at its most since last September, with 10-year TIPS priced for the consumer price index to increase at a 1.77% pace over the next 10 years, up 4 basis points on the day and a whopping 25 basis points for the week. This is troublesome in light of the fact that the U.S. economy is still extremely weak. Where will TIPS be when the economy turns?
TIPS will be one of many signals that the Federal Reserve will surely use as a gauge of when it should begin to either implement its exit strategy or warn about its impending implementation. At that point, interest rates will move higher across the curve, lead by the short-end of the curve. It is too soon for this in light of the fragility of the supposed recovery, so expect the yield curve to continue steepening. Fed Chairman Ben Bernanke spoke along these lines on May 5th when he said that "An important caveat is that our forecast assumes gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall." The translation is that the Fed can't yet reign in its balance sheet because there could be a relapse and the economic recovery could fail.
I would expect that concerns about sovereign credits will be a cyclical matter within a secular context. In other words, while the increase in government debts worldwide carry important implications about the standing of debtor nations relative to creditor nations such as China and Brazil, the diversification process will be more a process than an event, with concerns surfacing only now and then, as was the case this week.
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