Inflation Expectations on the Rise

Here's an interesting chart that strongly suggests that 10-year Treasury yields will be trending higher. The blue line is the 5-year, 5-year forward breakeven inflation rate as calculated by Barclays and as reported by Bloomberg. It's a way of extracting future inflation expectations by looking at the relationship between nominal and real Treasury yields along the yield curve. The blue line shows a tendency to lead the red line, which is another way of saying that the T-bond market is a little slow to pick up on underlying inflation fundamentals. Inflation expectations, as embodied in the breakeven spreads of TIPS—as well as gold and commodity prices—are rising. Treasury yields are perhaps being suppressed by Fed purchases of Treasuries and MBS, but I don't feel comfortable making that argument. I think it's just a case of the bond market being slow to the party as usual.

The blue line is something to watch very closely (especially now that it is within 8 bps of a multi-year high) since the Fed has said many times that this is its preferred measure of the market's inflation expectations, and the FOMC recently cited inflation expectations as one of the key indicators they will be watching for signs of whether or not they should tighten monetary policy. If inflation expectations continue to rise, the chances of a tightening will increase significantly, even though it will take a long time for the other indicators the FOMC cited (resource utilization and actual inflation) to sound alarms. Resource allocation (aka economic slack) and actual inflation are notoriously lagging indicators.

Disclosure: I remain long TBT and short a 30-yr. fixed-rate mortgage at the time of this writing.

Comments

[Gtarras:]

why would the author in a separate piece suggest to go long TIPS? wont TIPS tank if interest rates rise?

Nov 09 07:05 PM

[LaChic:]

Inflation Expectations on the raise? oh better look again..we already have Inflation.

Nov 10 08:12 AM

[stocknerd:]

Problem with all this inflation talk is: In case you havn't noticed we are STILL in a recession with no exit from such. There canot be inflation without the economy heating up and the economy is warm. If you look at the housing market, a great indicator of inflation, the economy is room temperature at best. Inflation is NOT in the near future. Sorry all the talk of inflation is premature and (conservative politics) wrong. There is no wolf. Sorry for all this sunshine.

Nov 10 09:42 AM

[richard_e_n...:]

Inflation is here now! It will soon get worse! The only sustained period of time since the Lehman collapse that there wasn't inflation was the three month stretch from October 2008 through December 2008. Since then Core CPI-U inflation is up at an annualized rate of 2.49% and CPI-U, all-items, inflation is up at an annualized rate of 2.66% (using the October numbers from bls.gov). Rear-view mirror, year over year CPI-U, all items inflation was -.29%. Concerning expectations, these year over year numbers being cited by main-stream econimic reportors are going to move dramatically upward in November and December (pronounced in December and January) where the comps will no longer support the deflation/no inflation balderdash. If you graph the CPI, month by month, as a function of time that graph has a visible slope that is the rate of current inflation. It is a straight line and in the absence of Fed action to restrain it, it will continue to be a straight line. That slope for CPI-U, all items inflation is 2.66%. The gives the truest picture of real inflation. So if you lend to the treasury by buying a 30 T-bill at .01% interest your are getting a real return of -2.65%.

Nov 10 10:08 AM

[Old Trader:]

Fwiw, I'm thinking we're in for another bout of stagflation, with some prices rising, because of higher cost inputs, via increases in commodity prices, while wages, etc. stay stagnant, due to excess supply.

Nov 10 06:18 PM