Expert Commentary

The Mad Hatter’s Deflation

"When I used to read fairy tales, I fancied that kind of thing never happened, and now here I am in the middle of one!" -- Alice's Adventures in Wonderland

In today's financial scene, you could be forgiven for thinking that you have fallen down a rabbit hole and entered a bizarre, topsy-turvy world where nothing is quite what it seems.

Negative interest rates and yields go against all economic sense and yet they exist in a growing list of countries around the globe. We also have a policy being seriously considered whereby governments can expand their borrowing and print new money forever with no consequences (Modern Monetary Theory). And then we have the term premium.

The term premium is the compensation investors require for holding a long-term bond compared to rolling over a series of short-term bonds with lower maturity. The chart below shows that the term premium on the 10-year U.S. Treasury bond is accelerating its collapse into negative territory. This means that investors, rather than being compensated for the risk of holding long-dated bonds instead of owning short-dated bonds and rolling them over, are actually happy to pay more and more for the privilege. This increasingly negative term premium can be interpreted a few ways.

It could mean that complacency is at an all-time high as nobody sees any risk at all in holding long-dated bonds as opposed to short-dated bonds. That complacency might be warning us of a future shock to the system.

It could also be because there is a natural and persistent buyer of long-dated bonds in the form of pension funds that have to match their assets with their liabilities.

However, it could also be a sign that people increasingly sense price deflation. A major factor in a positive term premium is that people expect to be compensated for the erosion of returns on long-dated bonds due to price inflation. Therefore, in the Alice in Wonderland world of a negative term premium, perhaps it is telling us that people increasingly not only expect no price INflation, but that they actually anticipate price DEflation. Crudely, a 1% nominal return on a 10-year Treasury with 2% price inflation leads to a real return of -1%. But a 1% nominal return on that same bond with, for example, 1% price deflation, leads to a real return of 2%. Price inflation is bad for fixed income investors. Price deflation, on the other hand, is a gift from the gods.

With negative interest rates and term premia becoming normal, the deflationary mindset so feared by central bankers and politicians could be setting in.

190925 MG