Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 17th July 2011.

The only major threat to the T-Bond

The difference in yield between the standard 10-year Treasury Note and the 10-year TIPS (Treasury Inflation Protected Security) is what we call the Expected CPI. The Expected CPI is not a realistic measure of the market's inflation expectations, but the direction in which it trends should be the same as the direction in which the market's inflation expectations are headed. The Expected CPI can therefore be useful, provided that we focus on its trend rather than its value. With this in mind, let's now take a look at weekly charts of the Expected CPI and T-Note futures. Both charts are compliments of Fullermoney.com.

A comparison of these charts reveals that important turning points in the Expected CPI over the past 5 years have coincided with important turning points in the Treasury market, with Expected CPI highs occurring at around the same time as T-Note lows and Expected CPI lows occurring at around the same time as T-Note highs. In other words, the charts reflect an inverse relationship between T-Notes and inflation expectations. This is hardly a surprise, as anyone with at least a modicum of knowledge about the financial world will appreciate that higher inflation expectations almost always translate into lower prices (higher yields) for long-term government bonds.

The idea we want to broach today is that the trend in inflation expectations isn't just an important influence on the trend in the government bond market, in cases where the government has a captive central bank it is so important that nothing else matters. If this is true, then an increase in the indebtedness of the US government will not lead to higher interest rates on long-term government bonds unless it leads to an increase in inflation expectations.

Japan's experience over the past 20 years suggests that the idea is valid. As a percentage of GDP, the debt of the Japanese government is now at 200% and rising. This is twice as bad as the US government's debt situation and is even worse than the debt situation of Greece. And yet, Japan's government pays an incredibly low rate of interest on its bonds (10-year Japanese Government Bonds are currently yielding about 1.1%). The reason is that inflation expectations are very low in Japan. They are low, and have been low for a very long time, mainly because Japan has had a slow rate of monetary inflation. Of course, Japan's government now finds itself in the position where it is acutely vulnerable to an increase in inflation expectations.

It is worth emphasising that the total domination of inflation expectations will only apply when the government in question has a captive central bank (a central bank that can always be relied upon to buy the government's debt if no other buyer can be found). Government bond yields in some euro-zone countries have rocketed upward independently of inflation expectations, but only because these countries do not have captive central banks capable of issuing unlimited amounts of new euros.

The upshot is that it only makes sense to be bearish on US government bonds if you have a good reason to believe that inflation expectations are going to rise. Due to the economic theories that prevail at the Federal Reserve, we strongly believe that US inflation expectations will rise substantially over the next few years. However, we are beginning to question our intermediate-term (6-12 month) bearish outlook for T-Bonds.

Anticipating QE3

There's a good chance that short-term trading positions recently established in anticipation of QE3 will backfire. The reason is that before the Fed starts a new round of aggressive money-pumping, it will need the cover provided by much lower prices for equities and commodities and a much weaker economy. The cover provided by a 'deflation scare', that is. This means that some of the things that traders are buying in anticipation of QE3 will have to drop substantially in price to make QE3 politically feasible.

If QE3 were to be introduced without the aforementioned cover then the Fed would quickly find itself in 'hot water'. The initial market reaction to the program would probably involve a sharp decline in the T-Bond and a strong rise in the S&P500 Index, but rising inflation expectations and interest rates would soon put an end to the stock market rally. Furthermore, in response to rising inflation expectations gold would start to make a beeline for $2000. In other words, introducing QE3 without the appropriate cover would result in all the negatives of QE2 with none of the perceived positives.

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