We have been in a disinflationary environment now for nearly 30 years. The first deflationary shock of this era were the advent of Paul Volcker’s monetary restraint measures and President Reagan’s supply-side fiscal measures in 1980. Next came the breakdown of the Berlin Wall in 1989. Then came the productivity revolution circa 1995 when via the Internet’s use began to spread. The next deflationary shock occurred in 2001 when China joined the WTO and began to export its deflationary labor market around the world.
And the latest leg of the disinflation/deflation process was the credit collapse in 2007-08 and this contraction is ongoing even in the face of the governments’ best efforts to cushion the blow. The difference is that core inflation is now closer to 1% and as we said above, is headed even lower. This means the critical inflationary component of bond yield determination will be heading even lower – long-term inflation expectations are still north of 2% -- even if the ‘real rate’ component remains sticky due to sky-high fiscal deficits and lingering sovereign credit quality concerns. It would not be out of the realm of post- bubble patterns of the past to see bond yields trend down in coming quarters and years to levels that could indeed ultimately retest the 2% lows in the 10-year T-note seen in the panic of late 2008.
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