By Eric Bush, CFA - Gavekal Capital Blog
10-year TIPS implied breakeven inflation made nearly a a seven year low last week as it fell to just 118 basis points. This was the lowest level since March 17th, 2009 aka, eight days after the infamous intraday "devil's" low of 666 on the S&P 500. Deflation was unquestionably the main fear in the market in the early part of 2009 as investors were concerned with the solvency of the entire financial services industry. Consequently, it is very notable that inflation expectations are now back at this nadir.
So what is causing this deflationary panic? The chart below would suggest China is (at least) partly to blame. In the chart below we plot 10-year and 30-year TIPS implied breakeven inflation against the 2-quarter percentage change in China's forex reserves. Over the past two quarters, China's forex reserves have fallen by 11.51% in USD terms.
The rate of decline has quickened over the last several quarters as the 2-quarter percentage change back in August was -6.4%. Since this time, 10-year breakeven inflation has fallen from 151 bps to 125 bps and 30-year breakeven inflation has fallen from 170 bps to 150 bps. If China continues to reduce its forex reserves, we would be hard pressed to see a compelling reason for inflation expectations in the United States to pick up anytime soon.