Inflation Expectations in the Bond Market

You know, every day there seem to be massive angst written about inflation expectations because the Fed cuts, etc. Now, for myself, I tend to believe that the dramatic rate decision can be approximated well by a third grader if the third grader was properly trained, but this article isn't about interest rate policy. It's about inflation expectations as viewed by the bond market. Now, of course, you probably have your own inflation expectations, which are real and valid. But one should also check in with market expectations to see if there's a matchup or not. So what is the market saying? The first thing to do, would be to look at the spread between TIPs, either 10-year or 5-year, depending on your timeframe and nominal treasuries. We can do that by skipping over to the www.federalreserve.gov site (.gov eh?). Perhaps there needs to be a new domain classification for central banks, like dot $$$.

Wait, we're getting off subject again. OK, so, what does the TIPs spread say? The spread between the inflation protected security and the nominal bond is essentially your market predicted inflation expectations, along with what I'd consider should be a risk premium for taking on inflation risk. So, the TIPs yield, should denote the real return and the spread to the nominal bond is inflation expectations + risk premium.

5-Year TIPs Yield: 1.79% - mmm.... the real yield is dropping. That's interesting. The market seems to believe the world is getting riskier. Can't imagine why that is!! I wonder if the spread is expanding, simultaneously, which would denote worsening inflation expectations?

5-Year Nominal Yield: 4.04% - more interesting. Inflation expectations + the risk premium of holding the nominal treasury is just 2.25%. Remember, there should be a risk premium in here.

Of course, I have a graph that I can't show right now, which lists a longer historical period, but let's just look in June and see how things have changed, or haven't:

5-Year TIPs Yield: 2.69% - apparently people were more willing to take risk, so demanded a higher real yield.

5-Year Nominal Yield: 5.07% - So that leaves a spread of 2.38%.

But wait, that would mean inflation expectations, actually haven't really changed much and even have slightly dropped through this whole period even with the rate cuts?! To be sure, yes, the TIPs will capture changes in oil and food prices, because it's not based on core. So all you can really say, is the market thinks the world is riskier and has been bidding down real yields on bonds, because it's scared.

What else does it say? It actually says the market has some faith in the Fed to keep price stability. I know that does not fit in with what many people believe. Unless of course you were to ferret out that there are possibly some forced buyers in the market, which cause distortions across the global sphere, (I certainly can't imagine any buyers like that!), but now we need to understand the scope of the distortion. If you were to think the market predictions are hogwash, well, of course you can vote with your money on what you believe to be uneconomic decisions by others. But you at least better be aware of what the market believes before you do so and have a satisfactory explanation for the difference. For myself, I can guess one potential market belief which explains the data, is that perhaps the market believes that inflation expectations aren't escalating, say because of an impending banana?