With the Fed's balance sheet exploding, and public debt at record highs, there is continuous worry these days about when inflation is going to rear its ugly head. One market indicator - the TIPS spread - is a helpful indication of the market's expectation of future inflation.
TIPS are inflation protected treasury securities. The principal is adjusted by the Consumer Price Index. The coupon rate is constant but produces different yields at varying rates of inflation as the principal changes, thus protecting the holder against inflation. Hence, the TIPS yield indicates the real return for the investor over the investment horizon, while the corresponding treasuries indicate the nominal rate. The gap between the two is the inflation compensation as demanded by the market over the duration of the bond.
The above graph shows the TIPS spread over the past 5 years for 10 year Treasuries.
The TIPS spread is currently around 2.5%. CPI is 2.2% per the November report and 2.0% excluding more volatile food and energy prices. This means the market expects inflation to go up moderately by 0.3% on average over the next 10 years. Not nosebleed territory by any means even with the rise in public borrowing.
One more important thing to note is that real interest rate is now negative for 10 year TIPS. This means investors are actually willing to pay the government an interest for the privilege of buying TIPS. This indicates that the market is in no mood to drive up interest rates any time soon.
1) Inflation expectations remain tame
2) The bond vigilantes are in no mood to push up interest rates
Taken together, this bodes for a fabulous 2013 for investors, especially in light of the improvement in the unemployment situation.