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Can Japanese Rates Happen Here?

The last time we visited the Oracle of Delphi was in July . Curiously enough, that was the last time I felt it necessary to proclaim that crude oil prices were headed higher.

The purpose then and in today's restatement is not to glamorize the substance-induced hallucinations of our pagan predecessors around the time of Halloween -- that would be wrong, wouldn't it? -- but to emphasize that free will does not always operate in the manner intended. After all, we baby boomers were raised to believe both religious wars and infectious diseases were things of the past. How well have those triumphs of the rational endured?

Whither Rates?

Rising energy prices certainly qualify as the dominant market story of 2004, but the persistent bull market in bonds has to be a close second. The links between these two developments have been the Federal Reserve's refusal to offset the implied tax increase from higher energy by continued monetary ease, and the decline in inflationary expectations engendered by the combination of a flattening yield curve and this implied tax increase.

To top off the confusion, not only have the inflationary expectations as measured by the spread between Treasury inflation-protected securities (TIPS) and regular government bonds decreased since May, they have inverted as well. The consumer price index (CPI) is expected to increase at an average rate of 2.625% over five years, but only 2.371% over 10 years. The TIPS market is making something of a path-dependent forecast, and those have a lower success rate than regular forecasts, which scarcely have a success rate at all.



Inflation Expectations At Various Horizons
Source: Bloomberg

The path of real, or inflation-protected, interest rates has been declining since the beginning of 2000. The rate of decline has been anything but steady, however: Its volatility has increased markedly since the beginning of 2002. More important for the direction of rates over the long term, each upturn in yields fails at a lower level.



TIPS Yields Retreat With Rising Volatility
Source: Bloomberg

For those wishing to blame bond rallies on either a failing economy or on the effects of mortgage-related prepayment hedging by the likes of Fannie Mae (FNM) and Freddie Mac (FRE), the burden of proof is on you.

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