Declining Treasury Yields & The Inflation-Deflation Debate
At this point, you would naturally expect me to write that I am right, and indeed I do believe that I am right about this. Still, while I believe that Mish is wrong, it can't be denied that he could be right theoretically (which is to say under different circumstances, falling bond yields could reflect deflation).
To get to the bottom of this, it must be asked what possible reasons could there be for falling Treasury yields. The answer to that question is that there are broadly 4 possible reasons why Treasury yields may fall:
1) Lower inflation expectations. This reflects more deflationary (less inflationary) conditions and is thus a symptom of deflation. Though it should be cautioned that expectations are a lagging indicator, and when there is a dramatic increase or decrease in inflation, the turnaround in inflation will happen later.
2) An increase in savings/a reduction in the government budget deficit. This is essentially neutral from the inflation/deflation perspective, though in the long term, the higher production capacity this enables will push down prices.
3) An increase in risk aversion/liquidity preference. As government bonds ( at least in the U.S.) are perceived as risk free and are the most liquid asset around, increased risk aversion and/or liquidity preference will lower government bond yields. This is also basically neutral from an inflation/deflation perspective, though it will mean tighter credit conditions for the private sector, which will have a deflationary effect. On the other hand, the lower cost of borrowing combined with weaker private sector activity could encourage government to expand the budget deficit which would negate much of the aforementioned deflationary effect.
4) An increase in the money supply that is used to bid up bond prices. This is the case where inflation pushed down yields.
So, theoretically, a decline in government bond yields could reflect inflation, be irrelevant from an inflation/deflation perspective, or reflect deflation. This implies that falling Treasury yields alone can't be used as conclusive evidence of anything. In order to tell what it implies you have to look at other data as well. This brings us to the issue of what it is a result from.
Is it a result of falling inflation expectations? To some extent, yes, as is suggested in the dramatic decrease in the spread between nominal treasuries and inflation-protected ones (TIPS). However, much of the decline in that spread reflects the much higher liquidity of nominal treasuries and the increasing liquidity premium. And there are also other strange aspects of the TIPS market that makes it less reliable as an inflation indicator. Even so, it seems likely that inflation expectations have declined.
Is it the result of rising savings/a falling budget deficit? Hell no! While private financial savings have increased, the dramatic increase in the budget deficit means that this factor has in ceteris paribus terms acted to raise Treasury yields-and raise it quite significantly. Hadn't it been for the counteracting effect of the other factors, this would have translated into much higher yields.
Is it a result of higher risk aversion/liquidity preference? That is clearly a factor given the sharp increase in the yield spread between Treasuries and various others more risky and less liquid bonds. Though it should be noted that this increase in the yield spread has come in the form of falling Treasury yields, and not higher yields of for example corporate bonds.
Is it the result of a higher money supply? Yes, it definitely is. This evening's weekly money supply release again confirmed the aforementioned upward trend, with M1 rising another 3% in just 1 week, while M2 & MZM rose slightly below 1% each for the week. The cumulative 9 week increase is 8.3% (annual rate of 58.1%) for M1, 3.3% for M2 (annual rate of 20.3%) and 4.3% for MZM (annual rate of 27.5% . The monetary base is up 68.5% in 10 weeks (monetary base numbers are only published for 2 week periods), or 1,408% at an annual rate. This means that the inflationary monetary trends I discussed last week continue and are accelerating.
Thus, while the decline in bond yields may to some extent reflect a reduction in inflationary expectations as a result of the monetary contraction earlier this year, the main reason is the massive flood of liquidity unleashed by the Fed, in interaction with the increased risk aversion/liquidity premium.