Thursday, December 31, 2009

A V-shaped recovery for inflation expectations

The green line in the top chart is the market's breakeven inflation rate for TIPS, and it's pretty clear that the action in the last year has described a classic V-shaped recovery (in inflation expectations). One year ago the TIPS market was priced to zero inflation, now it's priced to inflation of almost 2.5%, which was the prevailing level prior to last year's financial crisis. To get to this point, Treasury yields have surged, while the real yields on TIPS have plunged. If the economy continues to improve and the Fed continues to drag its feet on whether to tighten or not, we can expect to see more of the same in the coming year: rising Treasury yields and flat to lower TIPS yields. More interesting, perhaps, is that a continuation of this past year's trends will quickly lead us to uncharted inflation-expectations territory.

I've said many times here that the bond market is not a very good predictor of inflation, mainly because there are many times in the past when the bond market has been very slow to figure out the implications of the Fed's monetary policy. But it is true that the bond market sooner or later does figure things out, if only belatedly. I think we're seeing another instance of that right now.

The second chart looks at the valuation of TIPS on a stand-alone basis, irrespective of what the market's inflation expectations are. Here we seen that TIPS have recovered some value of late, thanks to a modest rise in real yields, but they are still somewhat expensive by my estimation.

What this all means is that the market is figuring out that monetary policy has an inflationary bias. As a result, people are much more willing to buy TIPS than Treasuries. People are willing to pay a premium, if you will, for the inflation protection you get with TIPS. Bernanke & Co. should be following this development very closely. If I could get close to one of the Fed governors, I bet I would see a bit of sweat forming on his brow.


Jay Norman Davis said...

As interest rates move higher should the share prices of PAI and EMD go lower.
As always, Thanks

Scott Grannis said...

Good question. Higher Treasury yields do not necessarily mean higher yields on corporate bonds or emerging market debt. It's likely in fact that rising Treasury yields will occur at the same time that yields on risky bonds decline or hold steady. That is the typical pattern for periods of spread tightening, and that is what we have been seeing recently. Junk bond yields are still quite high historically and are likely to decline if the economy and inflation pick up, since that would mean lower default risk.

Nevertheless, I wouldn't expect to see the prices of PAI and EMD go up by more than a modest amount over the course of the year. The bulk of the price gains have already happened.