New kind of deflation impels the great bond rally

A different kind of deflation is worrying the world’s central banks. The Federal Reserve began to back off planned increases in interest rates and reductions in portfolio holdings at the end of December, when equity and commodity markets crashed together.

A full retreat by the Fed as well as the European Central Bank arrested the fall in stock and commodity prices, but inflation expectations continue to fall in all major markets.

That’s a different kind of deflation, brought on by buyer resistance to price increases. We saw that vividly in the February report on the US labor market, where employers simply stopped hiring in sectors where wages had risen the most. We observe it in the housing market, where buyers are pushing back against higher prices, and (once again) in the market for wireless telephone service.

The worst performer on the S&P 100 today is Verizon, down more than 4% on investor fears that the wireless provider won’t be able to hold its pricing structure after T-Mobile merges with Sprint. A combination of technological change, market disruption and tight consumer budgets has steepened demand curves more or less across the board.

Across the world, the so-called breakeven inflation rate (the inflation rate at which inflation-indexed government bonds and ordinary bonds will pay the same total return) has decoupled from commodity prices. As the chart below makes clear, breakeven inflation in the US, Germany and Japan tracked the S&P/Goldman Sachs Commodity Index closely until the end of 2018. Germany and Japan decoupled first, then the US.

If we depict the same data in a scatter graph, we see clearly that inflation expectations embedded in the bond market have fallen farther than commodity prices would have predicted. The large black dots show today’s reading for breakeven inflation. In the US as well as Germany and Japan, the 10-year expectation of inflation is significantly lower than the trend line