Slate‘s Matthew Yglesias on the United States job report:
To understand why persistently high unemployment is avoidable, consider the “breakeven spread” between regular 10-year treasury bonds and inflation-protected treasury bonds. Since these instruments have the same duration and the exact same government backing them, the gap between the interest rates is an indicator of market expectations of inflation over a 10-year horizon. Ever since mid-March they’ve been slumping, probably because of bad news from Europe and the developing world. In particular, the eurozone crisis has increased demand for dollars while signs of a slump in China and India are reducing expectations for commodity prices.
Now normally you might think of reduced inflation expectations as a good thing. But one of the signature features of the Great Recession is that throughout the duration stock prices and inflation expectations have been closely correlated.
I watched the Twitter feed as the US job report was announced. It was a bearish reaction. A week before I had checked the Dow Jones sectors in Australia and the US on ThomsonReuters Datastream. From mid-March through April there were significant downturns in most Australian sectors although there was off-the-chart growth in defensive sectors like beverages and food.
A correlation between stock prices and inflation expectations is not unexpected. Equities investors hope to earn an equity risk premium usually of 5-8% annual returns compared with the risk-free rate of 3-4% in Treasury bonds and fixed income markets (and 8-11% for alternative asset classes like real estate and hedge funds). However, inflation risk can erode the rate of return between the two asset classes. Inflation can also affect the input costs (and hence cost structure and competitiveness) for publicly traded firms. Finally, many equities portfolios are highly exposed to beta market risk and are thus affected by currency and interest rate exposures, unless they are delta neutral hedged. QE3 will not solve these problems.
Image: Leader Nancy Pelosi/Flickr.