Chicken or Egg

Notice the rate move since last august, we have backed off for a few session but I think by summer rates will be a lot higher

A couple of week ago, I was listening to an earnings call where both management and the analysts were concerned with higher commodity prices. The analysts’ wording revealed their projections. No one asked about the company’s reaction “if” commodity prices went higher, but rather “with” higher prices, what will management do. I think most of the people in finance are convinced of coming inflation. Furthermore, editorial after editorial warns of the same problem. Though our inflation rate is still low (at least what they tell us), the level of concern out there is very high.

We’re not in the same place as last year. Back then, many warned of oncoming inflation, but the deflation side had plenty of supporters too – today it’s rare to find differing opinions. Disagreement instead focuses on how much inflation will there be when it surfaces. 

Given the growing consensus on inflation, why aren't Treasury yields higher? Well, maybe they would be without QEII. While QEII seems to be rather ineffective at pushing rates downward with the 30-year yield at 4.63% and the 10-year yield at 3.58%, there could be a lot of counter-factual information missing from this analysis.

It’s hard to explain how so many people have accepted the idea of future inflation, yet these expectations should not be reflected in today’s Treasury prices. Only an outside force such as the Fed can temporarily suppress rates from the market’s desired direction. Without QEII, 30-year Treasuries might have already been near 6% and 10-year around 4.50%. On the surface, QEII seems to have failed in its goals, but considering what rates might have been reveals a different angle.

In a way, this is a chicken-and-egg question. Did rates and inflation expectations slowly begin to rise due to QEII, or was QEII started due to fears of rising rates anyway? We can’t know for sure whether the first signs of inflation are the result of QEII or the past actions filtering through the system.

If the above scenario is correct, the Fed might have a tough time unwinding QEII. In June, we could see a large spike in rates as the Fed pressure lets up.