Enter Goldilocks?

A recent conference call by the Fixed Income strategists at a major NY investment bank set forth the following forecasts for interest rates and inflation:

• CPI inflation is likely to return to positive by year end 2009. However, slack labor markets and low capacity utilization at factories will cause core CPI (ex food and energy) to remain negative through 2010.
  
• The U.S. Federal Reserve is likely to engineer a gradual increase in the Fed Funds rate, but this firm did not expect the Fed Funds rate to reach greater than 1.25% by year end 2010.
  
• Because inflation expectations will remain anchored with the aid of a negative core CPI, 10-year treasury rates are not expected to surpass 4% between now and year end 2010. In fact, they may fall from current 3.5% to 3.00% within 12 months. (They are already down from 3.80% at the time of the call earlier this month.)
  
• The flattening of the yield curve is expected to lead the way higher for risky asset (stocks).

All of the above makes sense in my opinion, yet it is critically dependent on the ability to keep inflation expectations firmly anchored. The extremely high levels of liquidity that have been injected into the system by the Federal Reserve and other central banks will need to be artfully removed. We heard the first on this from the Fed in their statement following their meeting last week. In addition to making generally positive comments about the decline in the rate of deterioration in the overall economy, they also did not expand their program to purchase treasuries, mortgage backed securities, and U.S. Government Agency Debt. Not expanding this program was viewed favorably by the markets that have been looking for a carefully crafted exit to these potentially inflationary programs.

For those looking for a guidepost, the spread between the 2-year treasury and the 10-year treasury's interest rates is a usesful place to start. This has contracted since early June when the 10-year yield was 3.71% and the 2-year yield was 0.97% for a spread of 274 basis points. As of June 26th that spread stood at 242 basis points with the 10-year yielding 3.52% and the 2-year treasury yielding 1.10%.

Firmly anchored inflation expectations accompanied by economic data that is neither "too hot" nor "too cold," may well usher a new Goldilocks era.