Monday, November 9, 2009

Inflation expectations continue to rise



Here's an interesting chart that strongly suggests that 10-year Treasury yields will be trending higher. The blue line is the 5-year, 5-year forward breakeven inflation rate as calculated by Barclays and as reported by Bloomberg. It's a way of extracting future inflation expectations by looking at the relationship between nominal and real Treasury yields along the yield curve. The blue line shows a tendency to lead the red line, which is another way of saying that the T-bond market is a little slow to pick up on underlying inflation fundamentals. Inflation expectations, as embodied in the breakeven spreads of TIPS—as well as gold and commodity prices—are rising. Treasury yields are perhaps being suppressed by Fed purchases of Treasuries and MBS, but I don't feel comfortable making that argument. I think it's just a case of the bond market being slow to the party as usual.

The blue line is something to watch very closely (especially now that it is within 8 bps of a multi-year high) since the Fed has said many times that this is its preferred measure of the market's inflation expectations, and the FOMC recently cited inflation expectations as one of the key indicators they will be watching for signs of whether or not they should tighten monetary policy. If inflation expectations continue to rise, the chances of a tightening will increase significantly, even though it will take a long time for the other indicators the FOMC cited (resource utilization and actual inflation) to sound alarms. Resource allocation (aka economic slack) and actual inflation are notoriously lagging indicators.

Full disclosure: I remain long TBT and short a 30-yr. fixed-rate mortgage at the time of this writing.

8 comments:

Paul said...

Scott,

Is it easy to add the "share" widget thingie to your posts like Mark Perry, for example, has on his site?

Scott Grannis said...

Thanks Paul for the suggestion.

Family Man said...

Scott,
To avoid strong risky assets downtrend after this unexpected rise, FED can say that after reaching a given level of rates (ca 2%)in 2010, in next couple of quarters rates will be on hold, waiting for other factors to come.
I would not count on a "beginning of tightening" language only while the first unexpected hike happens.

Scott Grannis said...

Everyone seems to assume that risky assets will collapse as soon as the Fed starts tightening. While I'm willing to concede that the market might sell off for a bit on the news, that ultimately a tightening would prove very positive. Positive for the dollar, and positive for confidence. Higher interest rates are a net plus for the household sector, and higher interest rates are already built into the yield curve, so the market is not going to be blindsided when this happens.

Agustin said...

Please define "short" a 30 year mortgage in the context of the inflation expectations rising scenerio.

Donny Baseball said...

Fed Governor Lacker was on CNBC yesterday saying that inflation expectations "as best we can measure them are stable". Don't know what he's looking at...

Scott Grannis said...

Agustin: "Long" means you own something, "short" means you owe something. I'm short a fixed rate mortgage because I owe payments to the bank that lent me the money. That's equivalent to being short a bond with a fixed interest rate. In a rising inflation environment, interest rates would also likely be rising. That would depress the value of bonds and mortgages, and that would be bad for the owners of those things. Those who were short, however, would benefit from having locked in money at a low interest rate.

CFP, EA said...

Scott,

Glad to see that you're including the mortgage in your portfolio. I also like the way you explain its use.

A 30-year fixed mortgage is like shorting a really big bond. Except that unlike a normal short, you don't pay a price if you're wrong, i.e. interest rates/inflation fall. In fact, you win by refinancing to the lower rate, cutting your monthly expenses, and resetting the "short" on your mortgage at an even lower rate, which increases your chance that the best will pay off.

It's about the best deal out there.