A Chilling Complacency

Inflation has been in remission for so long that many in the bond market seem to feel it's no longer much of a threat.
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Bonds rallied last week after the


notified the world of its official new attitude. The "tightening bias" adopted by the

Federal Open Market Committee

means that, in the present opinion of a majority of the committee, the committee in the future is more likely to raise its Fed funds target than to lower it. No timetable, no commitment, no real meaning, and the bias has not been a particularly good leading indicator of actual changes in the Fed's policy target. A bias or lack thereof is effectively not much more than an expression of mood, and moods tend to change when conditions do.

But bonds rallied subsequent to the announcement. The thinking of the market, as interpreted for me by bond manager colleagues who do not themselves fully subscribe to such thinking, is that the announcement demonstrates that the Fed is fully aware of the possibility of an increase in inflation and is poised vigilantly on the ramparts. With such reassurance, the market can sleep better, and bid better.

I've never understood that particular strain of bond market logic. It proceeds thusly: inflation is deadly to fixed-income investments, so a stern monetary authority is a bond investor's best friend, so when the Fed administers monetary discipline, it is good for bonds in the long run, so bond prices should do better. That strikes me as a kind of intoxication of the long term, a market version of the rapture of the deep that lures divers to a disoriented doom.

If inflation is deadly to fixed incomes -- and it surely is, and not just to fixed incomes -- then it is indeed a relief to know that there is a therapy that can be effective against it. But effective does not mean pleasant. I'm blessed with a lack of much experience, but I've never met nor heard of anyone who thought chemo was a good time. The time for celebration is when it is determined that the therapy has worked and you don't need to take it anymore. That's when bonds ought to feel a sense of reassurance, and not when the FOMC shares with us the momentary mood of its majority.

Inflation has been in remission for so long that many in the bond market seem to feel that it is no longer much of a threat, that it may in fact be cured. That sort of complacency gives me a chill. Owners of notes denominated in baht or real know that domestic inflation soared when those currencies went under, and they know what happened to the market value of those notes. If you are convinced that there is nothing -- no act of commission or omission, by us or by others -- that can result in some shade of a similar fate for U.S. notes and bonds, then you too must now enjoy a serenity that I think you don't deserve.

If that sort of apathetic contentment truly reigns in the bond market, it makes me wonder whatever happened to the bond vigilantes. The vigilantes were bond managers with attitude, ready to sell first and ask questions later. Their image and

Clint Eastwood's

overlapped: grizzled and grim-jawed, tobacco-stained and smelling of the stockyard. Clint never let his guard down, and his vengeance could be disproportionately violent. Likewise, for the bond vigilantes of yore.

But now, with the range apparently pacified, today's bond managers are of a much sweeter breed. If they think inflation is dead and the blood-soaked range is now an endless sunlit prairie of clover and blue bonnets, their livelihoods are at risk. Big-eyed and trusting, regular bathers smelling of cologne and peach pie, dressed in bonnets and crinolines, today's vigilantes ride sidesaddle.

Before the year is out, it is quite possible that CPI inflation reports will be running regularly at more than 3% annualized. It is not difficult to get there from here. For fully two years now, core CPI services, which has fully a 69% weighting in the index ex food and energy, has been running at an inertial rate of 3%. But core commodity prices, the other 31% weighting, have drifted along at a mere 0.8% annual rate and so pulled the overall inertial core rate down to a 2.3% reading.

The total all-items CPI has been further tamed by an outright deflation in energy prices. This decomposition should be interesting for the following reason: it suggests that our headline CPI indicator is, and has been for two years, pivoting around a 3% inertial rate on its heaviest component. If energy and imported commodities simply stop falling in price -- they don't have to rise, but just stop falling -- the top line print on the monthly number will ratchet up toward 3% annualized. If energy prices hold their recent spike, and if import prices stabilize as a result of better global demand conditions or a failure of the dollar to continue rising, the monthly headline print could bungee up over 3%.

In his May 6 talk, titled "The American Economy in a World Context,"

Alan Greenspan

placed heavy emphasis on the role of productivity in holding down inflation, but he exhibited a sensitivity to the chance that, for whatever reason, unpleasant surprises are possible. "For, if productivity growth should level out or actually falter because additional technology synergies fail to materialize, or because output per hour has been less tied to technology in the first place, inflationary pressures could reemerge, possibly faster than some currently perceive feasible."

He's covered, and we're on notice.

I'll offer a different hypothesis for the rally in bonds that took place once the FOMC meeting was out of the way: the FOMC meeting was out of the way. The next meeting is scheduled for June 29-30, and so the market sees a high likelihood that the cost of money will be generally stable until that time approaches. Bond managers can justify taking a bit of maturity risk in order to accrue a bit of extra yield, but these are not conditions in which they are likely to do so in size or with conviction.

We got a little post-meeting trading rally that had little to do with the bond market's longer term view on inflation and everything to do with its near term belief about the cost of carry. It is a highly constrained and delimited rally. Bond markets will now exhibit a heightened sensitivity to commodity and currency price trends, will exhibit high anxiety as the CPI and PPI news release dates approach, and are likely to bunker down when the Fed next convenes to assess its own mood.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at