Sunday, April 26, 2009

Deflation risk disappears

This chart is Bloomberg's calculation of the 5-year forward expected inflation rate, 5 years from now (which is presumably the Fed's preferred measure of inflation expectations). As it shows, deflation risk was at its maximum right around the end of last year. Inflation expectations have since returned to where they were prior to the recent crisis. This can also be observed in the fact that 10-yr Treasury yields have risen by almost 100 bps since year-end, while 10-yr TIPS real yields have fallen by 50 bps. This reflects a strong shift in investors' preference for TIPS over Treasuries, which is consistent with a disappearance of deflation fears. If the line on this chart were to continue to rise, that would be an indication that the market is pricing in the risk of inflation rising to higher levels than we have seen in the past 10-15 years.

Of the two deadly risks that dominated the markets at the end of last year—depression and deflation—one has largely disappeared, and that is excellent news.

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