Inflation and the Yield Curve

Until unemployment drops in this country, there’s no possibility of the kind of wage-push inflation that spurred 1970s inflation. Inflation has ticked up in China, but there’s not much here.

— Roger Conrad, Utility Forecaster

Interest rates are going up. To be precise, long-term interest rates are going up. Although Ben Bernanke and the Federal Reserve are able to set the short-term Fed Funds rate near zero, market forces determine long-term rates. And the market is selling off long-term notes and bonds, causing long-term interest rates to rise (prices and yields go in opposite directions). Take a look at the U.S. Treasury yield curve, which shows rates all the way from 1-month bills to 30-year bonds:

Source: Bloomberg

Steepest Yield Curve in History!

It’s a very steep curve right now, especially between one year and ten years. The most popular spread to analyze is the difference between the two-year note and the ten-year note, although some economists recommend using the 3-month bill instead of the two-year note. With the two-year yielding 0.7847% and the ten-year yielding 3.6482%, the spread – or difference – is 286 basis points. The larger the spread, the steeper the curve, and right now the curve is near the steepest it has ever been in history.

Is the slope of the yield curve an accurate leading indicator of future inflation? Many academic papers have been written about the power of the yield curve to predict future economic activity. Most conclude that an “inverted” yield curve (short-term rates higher than long-term rates) is an excellent predictor of an impending recession, but that’s about it. A steep yield curve does not necessarily indicate future inflation; at most it indicates stronger economic growth and no likelihood of a recession.

Leading Indicators of Inflation are Pointing Upward

That said, the yield curve is a component of the Economic Cycle Research Institute’s Future Inflation Gauge (FIG), and the FIG is at a nine-month high. According to ECRI Chief Operations Officer Lakshman Achuthan, “underlying inflation pressures are starting to simmer.” The European FIG is even more alarming, rising to a 26-month high. Gold is often seen as a leading indicator of inflation and it has been trending up over the past year:

Source: Bloomberg

Wage inflation also concerns some bond investors. Employee compensation rose 2.1% last year, almost double the increase in 2009. And real average hourly earnings rose 0.4% year-over-year in December, the largest increase since 2008. Many economists view wage increases as very important to future inflation because wages make up such a large proportion of business costs.

Actual Inflation is Nowhere to Be Seen

Despite all this data, I’m not that worried about inflation for a number of reasons:

  • A 2000 Federal Reserve paper concludes that wage inflation “is not a reliable predictor of inflationary pressures.”
  • Gold prices could be going up for a number of reasons unrelated to the U.S. economy, including strong demand from emerging markets.
  • Investors could be selling long-term bonds to switch into equities, not because of inflation fears. So much of bond buying over the past few years has been a “flight to quality” trade based on fear of an economic collapse. Reversing this risk-aversion trade may simply be a healthy return to normalcy.
  • The “core” consumer price index (CPI), which excludes volatile food and energy prices, increased only 0.8 percent in 2010, the smallest December-December increase in the history of the index.
  • Unemployment remains high.
  • National housing prices continue to fall. The S&P/Case-Shiller housing index has fallen for six consecutive months.
  • Fed Chairman Ben Bernanke recently stated that he “expects the unemployment rate to remain stubbornly above, and inflation to remain persistently below” Fed target levels.

But perhaps my most important reason has to do with the “breakeven rate” between ten-year U.S. treasury notes and 10-year Treasury Inflation Protected Securities (TIPS). The spread between the rates of these two fixed-income instruments (i.e., the breakeven rate) directly measures investor expectations of future U.S. inflation. If you look at a long-term graph of the breakeven rate, it remains well contained:

Source: Bloomberg

At its current rate of 2.35%, the breakeven rate remains below the 2.7% peaks of the 2004-06 period, which was not an inflationary period. Consequently, until this chart shows an uptrend, I’m not going to worry.

Find the Best Inflation-Fighting Dividend Stocks with the Help of Utility Forecaster

With bond prices falling, dividend-paying stocks are the better bet right now. Unlike bonds, which offer only fixed rates of interest, dividend-paying stocks often raise their cash payouts. Consequently, dividend-paying stocks are an income investor’s only opportunity to keep pace with inflation. Roger Conrad, editor of the market-beating Utility Forecaster investment service, recently gave his subscribers the following advice:

Forecasting here in early 2011 that government deficits will crash the market by igniting inflation and wrecking the dollar has no basis in any hard number. It’s as fundamentally an emotional and political argument now as it was in early 2009. And it’s therefore extremely dangerous to your wealth.

That doesn’t mean the US dollar can’t and won’t fall further in coming months against other currencies. It’s in every investor’s interest to get some money out of the US dollar. My preferred vehicles are dividend-paying stocks of growing companies, particularly those in essential-service industries.

To find out the names of the electric, natural gas, and telecommunication utilities that Roger likes best right now, give Utility Forecaster a try today!