Tuesday, December 15, 2009

Inflation expectations -- another V-sign

This chart shows the breakeven inflation rate for 10-year TIPS (aka the market's 10-year expected inflation rate). It's simply the difference between the nominal yield on 10-year Treasuries and the real yield on 10-year TIPS. As should be obvious, after collapsing last year, inflation expectations have rocketed higher this year for a rather spectacular comeback. Inflation expectations haven't completely returned to the levels they were registering several years ago, but at this rate it won't take much longer to get there.

In one sense, however, inflation expectations are already breaking out to new highs, as shown in this next chart. It's the market's 5-year inflation expectation 5 years forward, as calculated by Barclays. It's now as high as it has ever been, with the brief and tiny exception of Mar. '08, and it looks like it's headed higher. In the annals of inflation, this past year—in which inflation expectations collapsed to zero only to fully rebound 12 months later—will undoubtedly go down as one of the great deflation head-fakes in financial history.

I can't resist referring back to my posts of late last year, in particular this one, in which I argued that "TIPS are a steal" because the market was projecting zero inflation but the Fed was hell-bent on reflating. If I were running the Fed, my message to fellow governors would be "OK, guys, job done: inflation expectations are back on track, now we need to get interest rates back on track."


jj said...

Your calls this past year on Tips, junk bonds, and emerging markets have all been spot on, as they say in the Navy, "Well done."

Bill said...


Mark Perry asks why the fuss over inflation expectations with M2 shrinking. Thoughts?

Fullcarry said...

Bill, Currently M2 is more a money demand metric. USTs owned by the public through money market accounts counts as money. When owned by banks, it doesn't count. The excessive money demand of late 2008 has been slackening off as evidenced by the price action of riskier assets.

Scott Grannis said...

Note my recent post which address Bill's question.

Charles said...

Inflation is at 4% over the last 6 months per the new CPI info. This is an extraordinarily high rate of inflation given the depth of the recession.

My friends tell me that manufacturing inventories are non-existent and staffing levels are at bare bones minimum levels. They expect bottlenecks to emerge very rapidly as demand picks up.