Sunday, September 21, 2008

Real yields are rising and that's good

This chart says a lot. The bottom line is the market's expectation for consumer price inflation over the next 5 years (and it is also the difference between the top two lines). The middle line is the real yield on 5-year TIPS. The top line is the nominal yield on 5-year Treasuries. Let's suppose we're in a recession now, as most people seem to think. If so, what is different about now versus the recession of 2001? First what's the same: both times inflation expectations fell, since the market believes (because of the Phillips Curve theory of inflation) that a weak economy will reduce inflation. Both times nominal yields fell, because a) the Fed eased in response to the weakness, and b) a weak economy increases uncertainty and the demand for the safe haven of Treasuries. This time, however, real yields are rising whereas they fell in 2001. That tells me that the market is significantly reassessing its expectations of Fed policy. Short-term real yields are heavily influenced by the market's perception of future Fed policy. Higher real yields mean the market is expecting the Fed to be tighter than was previously expected. That in turn implies a stronger underlying economy. Think of the real yield on short maturity TIPS as similar in some sense to the economy's expected growth potential. This is another reason to be bullish on stocks.

Update: the expected rate of inflation embodied in the TIPS market has risen sharply in recent days. That it had fallen so much was the anomaly.

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