Friday, December 12, 2014

TIPS see more growth, less inflation

Since March of last year, interest rates are up across the board, but some are up a lot more than others, and therein lies the tale—and it has a happy ending.

The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expected annual rate of inflation over the next five years. Since the end of March, 2013, nominal yields are up about 75 bps, but real yields are up about 200 bps. As a consequence, expected inflation has declined from 2.6% to just under 1.3%. As the chart also shows, expected inflation has only been this low or lower three times in the past 18 years, with two of those times being during recessions. Every time in the past that expected inflation has declined to the current level, it has been the result of falling nominal yields, and that usually occurs during times of economic weakness.

This time is different, since both nominal and real yields are up, and real yields are up by a lot. The big increase in real yields is great news, since it means the market is more confident in the economy's ability to grow. Nominal yields have fallen relative to real yields because the market correctly sees that inflation is going to be lower than expected, especially now that oil prices have fallen by 40% since March, 2013. But falling inflation expectations are coinciding with stronger growth expectations, and that's what is exciting and promising.

The relationship between real yields and the strength of the economy is shown in the chart above. The two tend to track each other, which should not be surprising. The real yield on TIPS needs to be competitive with the real growth rate of the economy, since the latter is what ultimately drives real yields on assets that in turn are driven fundamentally by the economy. By March, 2013, real yields had fallen to extremely low levels, which meant that the market was very afraid of another recession. Real yields have risen since then—even though growth hasn't yet picked up—because the market is looking ahead and seeing better growth fundamentals on the horizon. Recent evidence suggests that fourth quarter real GDP growth could bring us the first solid proof of a faster-growing economy. TIPS have been predicting that for awhile.

Real yields need to be higher still, just to be in line with expected growth, but we'll likely see that over the course of the next year.

The decline in inflation expectations is nothing to be worried about. Indeed, lower inflation is great for everyone except those who have too much debt. With the exception of the federal government, most households and businesses have undergone a lot of deleveraging since the Great Recession, so the private sector is in good shape to handle—and benefit from—lower inflation. As I noted the other day, the federal government's deficit is well on its way to zero, so even the public sector is not so exposed to the "dangers" of low inflation these days.

Arguably, the only thing we have to worry about here is the Federal Reserve worrying that low inflation is a problem.

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