TIPS see more growth, less inflation

Thanks to TIPS (Treasury Inflation Protected Securities), the U.S. bond market gives us a reliable and up-to-the-minute reading of the market's inflation expectations, unsullied by seasonal adjustment problems, immune to the ministrations of statisticians, and not subject to after-the-fact revisions. For the past several months, TIPS have been telling us that inflation expectations have been declining—though only moderately: deflation is still nowhere to be found. At the same time, the rise in real yields on TIPS tells us that the market is expecting somewhat stronger growth—though still far less than enough to erase the economy's huge output gap, which I estimate to be about $1 trillion per year.

It's a message that should do nothing to derail the Fed's plan to normalize interest rates at a somewhat higher level, and it should do nothing to provoke an outright tightening of policy. Slow and relatively stable growth, accompanied by relatively low inflation, is not very exciting, but it's not something to worry about either. It's supportive of continued, modest gains in equity prices.

In the chart above, the difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS gives us an expected annual (CPI) inflation rate of 1.27% over the next 5 years. This is relatively low compared to past history for this series, but it is nowhere near the levels that reflect deflation risk, such as we saw at the end of 2008.

As the chart above shows, the recent decline in this same expected inflation rate over the next 5 years is driven by and large by the price of oil. Lower expected inflation is not a symptom of tight money; it is the by-product of strong gains in oil production. As such, this is a welcome development, since a lower cost of energy enables a stronger economy.

The Fed's preferred measure of inflation expectations, the 5-yr, 5-yr forward expected inflation rate (derived from TIPS and Treasury prices) is 1.99%. The chart above shows the average expected inflation rate over the next 10 years, which is 1.59%. In other words, inflation is expected to average 1.27% over the next 5 years, 1.99% over subsequent 5 years, and 1.59% for the full 10 years. There's nothing unusual or worrisome with any of these numbers.

As the chart above suggests, the real yield on 5-yr TIPS tends to track the economy's growth rate. Which makes sense, since the real growth of the economy sets an upper limit on the real growth of its constituent parts. If the bond market is comfortable with risk-free real yields of 0.3% for the next 5 years, then real growth in the broad economy is quite likely to be somewhat higher. This year's increase in real yields suggests that the market is pricing in a modest acceleration in the rate of GDP growth over the next year or so. Nothing to get excited about, but nothing to worry about either.

The ISM manufacturing index has generally tracked the real growth rate of the economy. Its current reading suggests we should see GDP growth of at least 2-3% in the current quarter, a modest acceleration from the second quarter's growth rate.

July housing starts came in much stronger than expected (including revisions to prior months), and they are tracking well with a survey of builder sentiment. Housing has been expanding vigorously for the past 3-4 years, and there is every reason to expect further gains in the year ahead. This equates to a strong vote of confidence that the economy will remain healthy for the foreseeable future.

The physical weight of stuff carried by the nation's trucks increased 3.7% in the year ending July. This is a pretty good indication that the economy is growing. As the chart above shows, truck tonnage correlates reasonably well with the real value of U.S. equities. As the economy expands, real stock prices increase, which makes sense. The modest increase in truck tonnage in the past years suggests that the stock market is not in a bubble (neither undervalued nor overvalued), and is likely to increase modestly for the foreseeable future.