Tuesday, May 26, 2009
These charts focus on the market's inflation expectations, which are now almost back to "normal." The first chart is Barclay's calculation of the market's 5-year, 5-year forward inflation expectations, as derived from the difference between TIPS yields and Treasury yields. This is assumed to be the Fed's preferred measure of inflation expectations. The second chart shows the market's expectation for the average inflation rate over the next 10 years. Both charts show how expectations have almost returned to levels that might be considered "normal." The market is now expecting consumer price inflation to average about 2.5% for the foreseeable future.
The message to the Fed is clear: it's time to start taking back all the money that has been injected into the banking system over the past 8 months. Deflation risk has all but vanished. The economy is getting back on its feet (see previous post on consumer confidence). Swap spreads are almost back to normal. Liquidity is returning to the bond market. Equity prices are improving. We've most likely seen the worst of the housing market. The yield on 10-year Treasuries is up to 3.46%, and is closing in on the 4% level which I would consider a good sign that the economy has achieved recovery mode.
Will the Fed get the message? That is absolutely the key question for the months ahead. If they keep the pedal to the metal, their job (keeping inflation low) is going to be much tougher in the future. I think it is likely that they will be slow to react. That means that inflation risk is really coming to the fore.
The gold market has been foreseeing this development for some time; in my estimation, today's $950 gold price assumes that we will have a meaningful increase in inflation in coming years. If gold moves higher, that will be a sign that the market is not only becoming quite confident in a rising inflation future, but also confident that the increase in inflation will be significant.
Posted by Scott Grannis at 9:51 AM