Wednesday, February 9, 2011

Inflationary Expectations, the Dollar, and the 10-year Government Bond Yield

On Saturday, Allan Meltzer made the statement that “Inflation is coming.” Like the 1970s, we are in for another bout of high unemployment and inflation, which “flummoxed” the Federal Reserve’s policy committee and created a situation in which ”inflation and unemployment rose together throughout the decade.” (

The market evidence for this?

“Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness.”
The above chart shows that value of the United States dollar relative to the Euro. As the line rises the dollar weakens. In the early part of 2010, the Eurozone seemed to fall apart as the fiscal problems faced by sovereign governments created a financial collapse. The Euro declined against other currencies in the world.

By the summer of 2010, some quiet had returned to Europe and the Euro began to strengthen again against the dollar moderating late in the season around$1.27. However in late August 2010, Fed Chairman Ben Bernanke announced that QE2 was on the horizon and, as can be seen, the value of the dollar fell dramatically reaching the $1.40 neighborhood in November.

Although the value of the dollar rose again toward the end of the year, it again appears to be under siege as the dollar has fallen back into the $1.36-$1.37 range. So, in spite of its weakness, the value of the United States dollar seems to be losing ground relative to the Euro.

The key to this behavior Meltzer believes is the expectation of inflation. It is assumed by many that inflationary expectations get built into interest rates. I have just written on the current situation, the recent changes in inflationary expectations and the possible future movement in interest rates. See my post, “Long-Term Treasury Yields and Inflationary Expectations.” (

Here we have a chart the yield on 10-year Treasury securities. Note the decline in the yield that took place in the early part of 2010 to the fall. Many argue that this decline was due to a flight-to-quality as the investors left the sovereign debt of Eurozone countries and brought their money to invest in US Treasury securities.

Whereas the announcement of the coming of QE2 came in late August (and rates bounced up on the very next trading day after the Bernanke speech), the actual plan of action for QE2 was released in October and the Fed began conducting the QE2 in November. As can be seen in the above chart, the yield on 10-year treasuries has risen ever since. The last day in this chart is February 4. On February 8, the yield on the 10-year treasury security closed over 3.70 percent, a rise of 150 basis points since the late August date of Bernanke’s speech.

The argument can be made that participants in the financial markets are so sensitive to the possibility for future inflation that on the very next market trading day following the Bernanke statement, inflationary expectations began to build in the bond markets. And, the buildup of these inflationary expectations was also experienced in the market for the United States dollar and the dollar traded weaker even to the Euro even though the Eurozone was experiencing many fiscal and financial problems.
One can see this more clearly in tracing the value of the dollar indexed against major currencies. Here it is obvious that the dollar is trading at the lows reached over the past year and is even threatening the post- World War II lows reached in the summer of 2008.
It appears as if many investors in world financial markets agree with Allan Meltzer that, in fact, “Inflation is coming.” It is just the United States government that doesn’t see this.

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