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Now The Inflation Warnings Are Getting A Bit Worrisome
Call it yet another boost to the reflation narrative. Alternatively, you might call it a rather stark warning about the possibly imminent onset of actual, realized inflation.
The flash read on IHS Markit's US services and composite PMIs for February topped estimates, and the manufacturing gauge was essentially inline. But that wasn't the highlight.
Rather, the key takeaway was the color on prices. Which are rising. This is a case where quoting directly from the report is preferable to editoria
My 2 cents is to say that the jawboning of inflation hysteria is way too early and based on very little data. Sure the apparent recovery and reflation thesis is out there, but that whole pile of crap data needs to be placed into the context of a one-in-a-century pandemic event. The data related to a V-recovery, is what it is, but, as far as I understand, there is still a global pandemic in place — and a new virus variant has been very busy studying human immunology, and its transmissibility capabilities are going to be put to a test in the next several weeks. With that uncertainty ahead and so much damage within the last year, I don’t think it’s the right time to over-interpret or hyperventilate about inflationary anxiety. There are better things to worry about, like what happens to the 10-yr Treasury rate once the 2-yr Treasury heads below zero.
What dynamics and models do we have to explain that possibility? Inflation is a fairly easy bogey monster that most likely isn’t going to explode from under the bed and cause some hyperinflation nightmare — instead, pondering the nightmares related to an overheated equities market reacting to a totally distorted Treasury Dept, warped currency moves and the Fed trapped in a Black Hole, is a far more entertaining liquidity drama. For example, how will a sub-zero 2 yr Treasury impact mortgage rates or swaps or CDS or Bitcoin?
The pandemic drama isn’t over and IMHO, the Inflation Overture, currently playing will reach a sudden short crescendo fairly soon, then like Gamestop, something more substantial will swell in our hearts and minds.
Various Plumbing issues
IMF, Aug 2020
“The downside to yield curve control is that, given the size and global nature of the Treasury market, enforcing a yield target could require very large purchases of government bonds, which, in turn, could increase risks to the
Fed’s balance sheet (that would rise along with the duration of the bonds that are purchased).
Furthermore, there is relatively little empirical evidence on the extent to which yield curve control
can boost demand and support a faster recovery (especially when yields are already at historic lows).
Finally, capping yields will inevitably dampen the important price signals that the Treasury markets
provide (at least at shorter maturities).”
Re1: FRA-OIS, already at the tightest level in at least a decade, is about to go negative. Zoltan has more:
To have a view on FRA-OIS, we need to have a view on who will warehouse $1 trillion of reserves that will flood the system by June. Large U.S. banks won’t be able to unless they get SLR relief at the bank operating subsidiary level.
Re2: “The implications for FRA-OIS from here are obvious: if U.S. banks are full and money funds can’t take new money either, foreign banks will warehouse reserves at rates below those of J.P. Morgan but above those available in the bill market – and both are negative. The price of warehousing is a fee, i.e. a negative rate…”
Re3: “- Zoltan expects U.S. dollar Libor-OIS spreads to reach zero by June, with risks to the downside. “
Benchmark interest rates when the government is risky?
FRBFS
Patrick Augustin, et al, September 21, 2019
A small probability of U.S. Treasury default lowers no-arbitrage bounds of swap spreads to negative levels. Specifically, accounting for a U.S. credit risk premium in Treasuries is crucial if one wants to explain the dynamics of the term structures of multiple benchmark interest rates jointly. Even if the probability of a U.S. credit event is small, the risk premium associated with it may be large.