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Inflation? Deflation?

06/01/2010

In my last quarterly commentary I briefly discussed the critical question coming into this year - what is the path for 10 year Treasury yields?

Many investment banks included that 10 year Treasury yields would surge toward 5% in their "10 for 2010 projections."  Max Bublitz has done a great job taking the other side of that projection.  I agree on continuing to suggest that the 4% level is the so called "line in the sand."   Within my commentary I highlighted the significance of a "sustained" break above 4%, not a "Fast Flash."

As the chart below depicts, we have attempted twice - in June 2009 & April 2010 - to elevate beyond 4%, but failed. Let's look further into the failure to understand the deflationary forces that are creating resistance @ 4%.

U.S.  10 Year Treasury

Source: Bloomberg

Yes, investors are using Treasuries as a safe haven. The solvency issues in Europe, including Friday's untimely Fitch downgrade of Spain, contributed to yields falling back to the record low levels of December 2008. The spread between 2s and 10s came in toward March 2009 levels. But, more importantly, it is about acknowledging that the global fight is versus deflation, not inflation. Look below at the Consumer Price Index year on year. For 2010, prices are clearly displaying a "soft underbelly." Excluding China, India, and select Emerging Markets, the globe is absent of any robust growth. In fact I believe the austerity measures in Europe place the Euro Zone on the same GDP trajectory as the Japanese economy over the past decade.

Consumer Price Index

Source: Bloomberg

The path for U.S. GDP over the remainder of 2010 is not encouraging; the street is quietly chattering second half numbers of only 1 to 1.5% quarterly GDP figures. Consumer spending in April showed signs of moderating, as did the housing data. On Friday, it was reported that 1st quarter GDP grew below consensus @ 3.0%  -  blame the real final sales component which rose at a modest rate of 1.4%. Look at the chart below for real final sales - for the second half of 2009 and into 2010, sales are stagnant.

U.S. Real Final Sales

Source: Bloomberg

What this all means to investors is that the low private sector borrowing costs that are currently in place must remain. The steep yield curve trade will remain; financial institutions will continue to benefit by strengthening their balance sheets and purchasing Treasuries. That low interest rate environment should contribute in the prevention of this month's capital market weakness evolving into a Fall 2008 market once again. Understand that this is about deflationary forces, making a difficult battle for Global policy makers but a battle in which the U.S.seems to be well ahead of the global curve.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.