Now Hear This: The T-Bond Market is Forecasting Higher Inflation

Wednesday's trading in the U.S. Treasury bond market broadcast an important economic signal -- that investors are building higher inflation into their forecasts. As the Treasury attempts brings to market an estimated $3.25 trillion in bonds during the 2009 fiscal year (ending Sept. 30), rising yields suggest that investors lack confidence in the Fed's ability to control inflation, and in turn, long-term interest rates. Today the difference in yield between the two year and 10 year Treasury bonds widened to a record, 2.75 percent -- one basis point higher than the spread on August 13, 2003. (A basis point is one one-hundredth of a percentage point.)
The Treasury bond market is the world's largest, and its capital flows and prices reflect the views of investors from around the globe. Because its signals are so loud and clear, it's important to listen to what they're saying. So what's the message in a record wide 2.75 percent spread between the two year and the 10 year Treasuries?

Treasuries are the safest investment around, in terms of credit risk: the U.S. government has never defaulted. Therefore swings in yields on longer-term T-bonds are dominated by changes in the market's view of expected inflation, which translates into the additional return investors demand to maintain the purchasing power of their principal.

As we've written before, if history is at all a reliable guide, the enormous fiscal and economic stimulus that the federal government is forcing into the U.S. economy is likely to produce inflation -- an excessive amount of money competing for a limited amount of goods.

The Federal Reserve has been buying back some of the bonds the Treasury will issue in the stimulus efforts. So far, the bond market has responded favorably, keeping T-bond yields at historically low levels. And because mortgage rates are closely tied to 10 year Treasury yields, the cost of financing a house has remained low as well. But interest rates are creeping up.

It's not that investors don't want to own Treasuries -- an auction of five-year bonds yesterday drew bids twice as large as the amount of bonds being sold. But as the eventual economic recovery starts to appear on the horizon, investors are getting a better look at how the stimulus might play out, and are insisting on getting paid for the inflation risk.