Great (Inflation) Expectations

Great (Inflation) Expectations


For those of you who have met me or have read my articles before, you know that I am a sports fan and that my loyalties lie with the San Francisco Giants and 49ers. With my teams finishing on opposite ends of the spectrum, 2010 proved to be an up and down year emotionally, but in the end, I learned a very valuable lesson. Expectations matter.

Nobody, including me, thought that the Giants would make the playoffs this year let alone win the World Series, their first since their arrival in San Francisco in 1958. Even when an unexpected series victory over the Atlanta Braves in the first round of the playoffs set them up against the heavily-favored Philadelphia Phillies in the National League Championship Series, I said to myself, “Even if they lose, it has been a memorable season.” While a World Series victory for your favorite team always elicits feelings of unbridled joy, it feels especially sweet when you never saw it coming. Sorry, Yankees fans, but it’s the truth.

While the Giants were making their push towards the playoffs in early September, the NFL season was gearing up, and many experts were picking the 49ers to win their division and make the playoffs for the first time since 2002. Unfortunately, I bought into the hype and expected a winning season. Sixteen games later and the Niners were going home after finishing the regular season 6-10. The season proved especially frustrating because my expectations were so high.

To help moderate my emotions going forward, my plan is to enter every new season with low expectations. If my team does well, then my elation will be heightened. If they don’t, then my disappointment will be tempered. Seems like a win-win to me.

Quantitative Easing . . . the Sequel

On November 3, 2010, the Federal Reserve embarked on a second round of “Quantitative Easing,” an economically euphemistic way of saying that they would print money to buy longer-term bonds to keep interest rates low to help stimulate the economy. They already implemented such a plan once, between November 2008 and March 2010 when they focused their attention on mortgage bonds to drive rates down to help support an ailing housing market. Their plan worked. During the program, mortgage rates fell and the benchmark 10-year Treasury yield remained relatively range-bound. It seems that their success along with the stubbornly high unemployment rate played a role in their decision to launch the second phase, dubbed “QE II” by the financial media.

As for QE II, so far not so good. Despite the Fed buying hundreds of billions of dollars of longer-term bonds (this time the focus is on Treasuries), both the 10-year Treasury yield and mortgage rates have started to climb. As a result of rising yields, the bond market has fallen 2.3% since the start of November, as bond prices move inversely to interest rates.

Interest Rates are Rising Because of QEII Not Despite It

Die-hard sports fans are not the only ones who need to pay close attention to expectations. Bernanke and his colleagues at the Fed need to as well. While QE II is the same as QE I in terms of procedure and strategy (aside from the focus shifting from mortgages to Treasuries), the economic environment has changed from one of recession and deflation then to one of mild expansion and inflation now. As a result, bond investors’ expectations of inflation are increasing, forcing them to demand a higher rate of interest as compensation. The Fed’s desire to throw more monetary stimulus at an improving economy only serves to heighten those expectations for inflation and the demand for higher rates.

The Fed is authorized to use up to $600 billion in newly created money to buy bonds as part of QE II. They have been making purchases since November and plan to continue through June. While the $600 billion in bond purchases will take place over an eight month period, the average daily volume of the U.S. bond market was about $900 billion in 2010, which should serve as a reminder to the Fed exactly whose expectations matter in setting long-term interest rates. For bond investors, this means being wary of rising rates—despite the presence of the Fed in the marketplace—by staying short to intermediate on the yield curve and overweighting spread product relative to Treasuries.

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