Tuesday, June 9, 2009

What's going on with the yield curve?

Milton Friedman famously proclaimed that “inflation is always and everywhere a monetary phenomenon”, implying that inflation is inextricably linked to the money supply. This thinking has lead some analysts and others to voice heightened fear that monetary stimulus provided by the Bank of Canada, and the Federal Reserve in the United States, can only lead to a resurgence in inflation.

Proponents of this view point to the recent increase in the slope of the government yield curve as a clear signal that purchasers of government treasuries, fearful of the impact of massive monetary and fiscal stimulus, are ratcheting up their inflation expectations and demanding a higher yield on long-term debt. Still others view the steepening yield curve as a positive signal of expected future growth and the end of the recession. So which is it?
Looking at inflation expectations derived from Canadian real-return bonds, it is pretty difficult to conclude that Canadians, or buyers of Canadian debt, expect runaway inflation on the horizon. Inflation expectations seem to have ticked up recently, but I think only because a Great Depression II induced deflationary spiral seems to be off the table. Moreover, expectations remain firmly anchored in the BoC comfort range

It is also hard to conceive of a scenario in which inflation could get out of control while the economy is operating so far below its potential.

My own opinion is that the increase in the slope of the yield curve is a function of the following factors (in no particular order):

1) Flight from quality – investors getting out of treasuries and back into riskier assets

2) Normalized inflation expectations – fears of a deflationary spiral seems to have been successfully beaten back by the Bank of Canada

3) Expected Government borrowing due to larger than anticipated fiscal deficits

4) Expectations that the worst of the recession is over and the economy will return to positive growth soon.

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