Is US bond market not pricing in enough inflation?

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Is US bond market not pricing in enough inflation?
Over the past few weeks, this column has been pointing out how only a mild appreciation in the Dollar Index and US 10-year yields staying well below three percent are defying the Federal Reserve's forward guidance. One of the major factors behind these market moves is that the market believes that US inflation will not pick up at the pace the policymakers expect it to and this in turn will defer the first rate hike by the Fed.

But what happens if this is not the case? Firstly, as UBS research report points out, the labor market may be tighter than the unemployment rate suggests.

According to UBS, more small businesses are reporting difficulties in finding qualified job applicants. Although the headline unemployment remains over six percent, there are specific skill shortages in industries such as construction, agriculture and energy. This implies that there remains a large pool of longer-term unemployed persons, but some recent academic research suggests they have less influence on wage inflation than the shrinking pool of the shorter-term unemployed. Research by Alan Krueger and two of his Princeton University colleagues suggests that the longer-term unemployed have less impact on wage inflation than the shorter-term unemployed. Thus, there is a possibility of an upward revision in wages which would also drive inflation higher. Janet Yellen, the chairwoman of the Federal Reserve, has pointed out in the past that the current rate of growth of average hourly earnings (1.9 percent) is only half of what it would be in healthier labour market conditions.

So how will the rest of 2014 play out for US 10-year yields? They have stayed stubbornly below three percent so far and a sharp spike up in the coming weeks seems unlikely. UBS places a high probability that this event may play out towards the end of the year. Further, as their analysis points out, the market implication of the potential future rally in yields will go well beyond the US bond market. All assets with a correlation with the US duration will be affected. G 10 government bond yields along with the dollar will all rally firmly towards the end of the year. Commodities, most notably gold, could suffer on the account of a stronger dollar.

This is not bad news for the equity market yet. This is seen as the passing of the baton from the Fed's easy money monetary policy to a self-sustained real US economic recovery. This is the basis for all the bullish forecasts for the benchmark S&P 500 index. UBS is looking for the US 10-year treasury yield to reach 3.25 percent in December 2014 and four percent at the end of 2015. Similarly, it expects the two-year yield to be 0.75 percent in December 2014 and 2.50 percent in December 2015. In this scenario, UBS strategists expect the Fed to boost the Funds target in mid-2015, pushing the rate to 1.25 percent by year-end 2015 and 3.25 percent by year-end 2016.

Thus, we must keep a very close eye on any data suggesting an uptick in US inflation. Long positioning in the dollar and US yields seems inevitable. The question is whether the move up will be gradual or a rapid rise towards the end of 2014.

(29-05-2014. Vatsal Srivastava is consulting editor for currencies and commodities with IANS. The views expressed are personal. He can be reached at vatsal.sriv@gmail.com)

Story first published: Thursday, May 29, 2014, 13:42 [IST]
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