Tuesday, July 20, 2010

Inflation Outlook Continues To Fall

Foreign countries are reducing their holdings of US treasuries as demand for US long term debt appears to be weakening. Meanwhile, speculation over deflation is increasing as the 10 year inflation outlook continues to fall. See the following post from The Capital Spectator.

The Treasury market's 10-year inflation forecast slipped last week, and more of the same looks likely for today. The yield spread between the conventional and inflation-indexed 10-year Treasuries dropped to 1.71% on Friday, down 10 basis points from the week before and well below late-April's 2.45%--the previous peak. The debate about deflation—is the risk rising?—is likely to be front and center this week. That's likely to fuel more buying in Treasuries.

“U.S. Treasuries are still attractive,” Sungjin Park in the fixed-income department at Samsung Investment Trust Management in Seoul told Bloomberg News. “A double- dip recession is inevitable” in the U.S.

Inevitable? That's a bit strong. But the risk surely isn't fading. And there's no denying that the public demand for Treasuries is rising. Adding to the momentum to chase government bonds is last week's news that headline consumer price inflation retreated by 0.1% last month—the third straight month of decline. "The latest string of reductions of the CPI is significant and raises questions about the probability of a deflationary situation," advises Asha Bangalore of Northern Trust in a research note.

But before we concluded that even lower rates are fate for an extended period, consider the recent dip in foreign demand for U.S. assets. AP reports:
China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

The report said that total holdings of Treasury securities edged up $5.8 billion to $3.96 trillion in May, a slight increase of 0.1 percent compared to April.

The Treasury said that net purchases of long-term securities, a category that covers not only U.S. government debt but also debt of U.S. companies, increased by $35.4 billion in May. That followed bigger gains of $81.5 billion in April and $141.4 billion in March.
The deflationary pressures may be mounting, but offshore demand for Treasuries is likely weakening, at least at the margins. It's unlikely that China and other large holders of U.S. government debt are going to start selling their massive holdings of Treasuries. But it's also unlikely that there's a growing appetite for buying huge quantities of additional Treasuries going forward. Yes, the dollar's still the world's reserve currency, and that's not going to change anytime soon. More flows in the greenback are destiny for the time being. But...

According to Dow Jones: "China should reduce the amount of U.S. dollar-denominated assets in its foreign exchange reserves in favor of those denominated in other currencies or other types of assets, former People's Bank of China adviser Yu Yongding wrote in an article published in the state-run China Securities Journal on Monday."

Nonetheless, last week was a good one for going long Treasuries. The iShares Barclays 20+ Year Treasury Bond ETF (TLT), for instance, was up about 1.6% on Friday vs. the weak-earlier close. And for the year so far, TLT has climbed more than 12% vs. a 4% loss for the S&P 500 Spider ETF (SPY). Treasuries are hot, and stocks are not. Deciding if that holds will depend on how the deflationary game plays out. As usual, it all looks clear…until it's not.

A few months ago, the notion that deflation was again lurking was widely dismissed. Today, it's on everyone's mind. The only thing for sure is that betting the farm on one outcome is a short cut to big gains…or big losses. For everyone else, a bit of hedging is in order.

There are lots of moving parts for deciding what comes next. That starts with wondering: Will the Fed roll out a new round of monetary stimulus in an effort to slay the D risk? What are the odds that Bernanke & company will sit on their central banking hands and watch the market's 10-year inflation forecast fall even lower in the days and weeks ahead? Will they really do nothing if the inflation outlook drops to 1.6%, 1.5%, or lower?

This article has been republished from James Picerno's blog, The Capital Spectator.

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