Woodley Farra Manion Portfolio Management


	Recent Bond Market Behavior

	October 19, 2010 For all the talk about the expectation of significantly lower interest rates, the market has now begun to anticipate higher inflation, especially since mid-August when Bernanke announced the possibility of quantitative easing #2 (QE2). The attached chart show the difference between the nominal 10-year Treasury and the inflation-protected 10-year note. The gap shows the implied rate of inflation expected by bond market participants for the next 10 years. The first QE program (meaning the Fed began to buy massive amounts of mortgage and other debt) was kicked off in early 2009 at the height of the financial meltdown. The nominal 10-year note rose from 2% to 4% in the next 12 months or so, and inflation expectations returned to pre-crisis levels. Now the 10-year note is at 2.53% and has been increasing in yield the past 10 days. Last week’s long bond auction was a disappointment as investors demanded higher yields than the market was providing and the inflation expectation climbed back above 2% for the first time since the end of May, when the markets were dealing with the Euro crisis and investors were buying Treasuries as a safe haven. The current QE program would involve the Fed buying Treasury securities to reduce their supply and therefore lower interest rates. There is only so much the central bank can do given the size of the Treasury market (it is the world’s largest asset class) and the recent trends in longer term interest rates (i.e. higher!) may indicate that the intended effect (higher inflation expectations) may have been achieved without firing a shot. The media seems to think we are headed on the brink of deflation due to QE talk. Look below for the market reaction. Click for larger version.