I see a decline in inflation breakevens and the continuing flattening of the yield curve as being a very worrisome signal about the FOMC’s credibility.
There is distinct lack in the Fed’s ability and/or willingness to achieve its mandated objectives.
If you analyze the five or ten-year breakeven (the difference in yields between a standard (nominal) 5 or 10-year Treasury and an inflation-protected 5 or 10-year Treasury (called TIPS)). The, the five-year/five-year forward breakeven is defined to be the difference between the 10-year breakeven and the five-year breakeven. What these spreads imply are investors’ best forecast about what inflation will average 5 to 10 years from now, as well as the inflation risk premium over a 5-10 year horizon five to ten years from now - that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
Both risk premium and forward inflation expectations show that the Fed are way off their 2% annualized inflation target. This decline is a troubling signal about FOMC credibility.
Simply put, the FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. The way the yield curve is now shaped and the decline in the breakevens show that investors are demanding less compensation (in terms of yield) for bearing inflation risk.
But Treasuries are only a better hedge than TIPS against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. The decline and flattening of the yield curve reflects investors are assigning increasing probability to a scenario in which inflation is low over an extended period, while at the same time where employment is also low - that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.
And yet the FOMC is continuing to tighten monetary policy in the face of marked deflationary pressures.
‘How can this be” the man in the street will be asking.
You are telling me that after all that austerity, all that QE, all those years of low interest rates, and all those promises of imminent recovery, that we are now at risk of another crisis and falling living standards? Do you guys really know what you are doing, because it seems pretty obvious now that you do not. You are just a bunch of optimists, wishful thinkers and tinkerers with a good line in spin, but basically incompetent.
Back when the financial crisis began in 2007 (and to be honest I do not believe it has ever gone away) it would seem the idea of “spin” seemed the only way to keep the markets from an even larger panic. The hope was simply that the grand ZIRP experiment would kick start the economy and allow governments to pay off the losses that were transferred from the “too big to fail” banks’ balance sheets, effectively into sovereign debt. However as we enter 2016 at a time when, cyclically, we are due a “downturn,” it clearly has not achieved its goals.
Given the current risks it may seem wise for the Fed to reverse course, however, given that their final bullet will be “helicopter money” as their final throw of the dice,
the price will be a severe reduction in credibility and a potential collapse of the fiat currency. It seems they may have painted themselves into a corner.
These are very dangerous times. When trust and confidence is lost, political change is not far behind (re: a certain Mr. Donald Trump and as TIME observes, “For many, if not all, of these individuals, their networked relationships with Trump feel closer and more genuine than the images of the candidate they see filtered through the middlemen.” This can explain why Trump is unscathed by apparent gaffes and blunders that would kill an ordinary candidate.).
Week 1 of the New Year was alarming, week 2 has doubled up on that alarm. The commodity price collapse has morphed into a full blown crisis that threatens the solvency of countries, companies large and small and the lenders who have underwritten their loans. As many of these countries are 'emergers', whose debt burdens have exploded since 2008, of which at least 50% is denominated in foreign currencies, the world has moved into the third leg of a financial crisis that continues to simmer. It began with sub-prime in the US, moved onto the Eurozone and is now enveloping emerging markets, with debt in one form or another the common denominator.
For all their rhetoric, risks are increasing, and as more and more people notice that the the Fed governors really do not know what to do, the more disastrous it could end up being.
In regards to more detailed options and futures advice volatility analysis etc ,please contact Darren Krett,Bryan Fitzgerald or John Hayden through www.leviathanfm.com or email at [email protected]
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