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Bernanke's Date With Deflationary Destiny

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If the market makes critical levels in the 10-year Treasury and US bond futures contract support, and fundamentals continue to deteriorate, we could see a significant rally.

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What if the 10-year yield actually belongs at 2.0%?

The first reading on Q4 2012 YOY nominal GDP (NGDP) growth was a bleak 3.3%. This was the lowest print since Q1 2010's 2.5% which was the first quarter of positive real growth coming out of the recession. Likely because the stock market was at new highs at the time of release, the first interpretation was that it was an anomaly caused by a sharp drop in government spending. However the 3.3% growth rate matches up pretty well with Q4 earnings reports and recent comments from consumer product companies.

Every week Bloomberg's Rich Yamarone publishes his "Orange Book," which is a fascinating compilation of anecdotal comments from corporate executives on their earnings conference calls. Without going into the massive detail Rich accumulates after reading a few of the comments from the likes of BEAM Inc. (NYSE:BEAM), The Clorox Company (NYSE:CLX), Tyson Foods (NYSE:TSN), Whirlpool (NYSE:WHR) and Elizabeth Arden (NASDAQ:RDEN), the net takeaway remains depressing.

The Bloomberg Orange Book Sentiment Index for the week ended Feb. 22 was 48.67, a slight decline from the 49.47 registered during the prior week. Sub-50 readings suggest contractionary conditions, while above-50 is indicative of expansion.

10YR Yield Vs. YOY Nominal GDP



There is a fairly consistent relationship between NGDP and interest rates. As you can see on the 50-year chart, historically NGDP and 10-year yields tend to converge. Obviously there have been statistical outliers, but eventually the 10-year yield equals the growth rate of the economy, and over the 50-year history the average spread between the two is just 17.5bps. If you think about it this makes sense as a risk-free government bondholder should, over time, at least be compensated for nominal economic growth. The current spread of -155bps is inside 1 standard deviation and looks to be converging towards zero. The question is whether the spread converges with yields rising towards 3.3% or nominal growth falling towards 2.0%.

One likely factor contributing to the weakening nominal growth rate is the fall in inflation. This week's Fed minutes showing concern about the risks of QE were juxtaposed with the January readings on producer and consumer prices. The YOY PPI came in at a mere 1.4% with CPI registering a 1.6% gain falling from the December 1.8% rate. This 1.6% gain is notable because it is near the lower bound of inflation rates over the past 10 years and is not far from the levels in 2010 that raised deflationary fears at the Fed and brought about QE II. It also flies in the face of the market's inflation expectations which according to the 10-year TIPS (Treasury Inflation Protected Securities) inflation breakeven spread implies a 2.5% CPI, near the recent historical highs.

TIPS B/E Vs. CPI



As you can see on the chart's lower frame, this divergence between the market's inflation expectations and actual inflation has reached a historically wide level near 100bps. With the exception of the 2009 blowout, the last two times this spread reached 100bps was in 2010 and 2006. This relative cheapening of nominal vs. real yields occurred for very different reasons but eventually produced similar outcomes. In 2006 as the housing market was peaking, actual inflation began to fall yet inflation expectations remained high. In 2010 it was the opposite as inflation was already low but inflation expectations spiked due to QE II. Both spread divergences, however, preceded massive rallies in the 10-year eventually pushing yields lower by nearly 200bps on each occasion. It's highly unlikely we see a rally of that magnitude, but this spread divergence should be supportive of the long end of the curve, and contrary to consensus, could be signaling significantly lower yields in the near future.
No positions in stocks mentioned.
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