Where Did The Rise In Inflationary Expectations Come From?

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Summary

Over the past several weeks, inflationary expectations rose in the United States resulting in a rise in the yields on longer-term Treasury securities.

It has been difficult to pinpoint where this rise came from since economic growth is not that strong and the Federal Reserve doesn't seem to expect that much future inflation.

There is some reason to believe that British Prime Minister May kicked off market changes hitting both the foreign exchange markets and the bond markets with her approach to Brexit.

What's going on? A little more than a week ago, it seemed as if market expectations about future inflation were substantially different from the inflationary expectations of the Federal Reserve.

Federal Reserve projections of inflation were for a rise in prices of 1.8 percent in 2016, followed by inflation rates of 2.0 in 2017 and 2018.

At the time, inflationary expectations built into the Treasury bond market indicated that for a five-year horizon and a 10-year horizon, were somewhere around 1.6 percent.

At the market close yesterday, inflationary expectations in the bond market for the same horizons were over 1.7 percent and seemed to be rising.

Furthermore, if one traces the changes in expectations in the market place, the rise since early July of this year is even more dramatic. At that time, inflationary expectations were just over 1.4 percent for both the five-year horizon and the 10-year horizon.

What hasn't changed much since the early part of July is the yield on five-year and 10-year Treasury Inflation Protected securities (OTC:TIPS). At that time, the yield on the five-year TIPS was around a negative 45 to negative 50 basis points. The yield on the 10-year TIPS was around a positive 5 to a positive 10 basis points.

Over the past few days, the yields on these TIPS were around the same level.

The interesting thing is that the yields on the TIPS were much higher around the end of last year. The yield on the five-year TIPS was between a positive 45 and a positive 50 basis points. For the 10-year TIPS, the yield was in the positive 80 to positive 85 basis points.

What happened after the first of the year is that a lot of risk-averse money flowed into the US bond market from foreign markets and this had the effect of driving the yield on TIPS lower.

By the end of February, the five-year TIPS yield was in negative territory; the yield on the 10-year dropped below a positive 40 basis points. The yield on TIPS just kept going lower into the spring and into June.

I mention the month of June because it was toward the end of June that Great Britain voted to exit the European Union. This seems to be the next turning point, which has now been reflected in the rise in inflationary expectations.

What has changed that has resulted in this rise in inflationary expectations? Because there seems to be no movement in the risk-averse international money because since early in July there has been little or no change in the yield on the TIPS.

In terms of the Federal Reserve, the market expectation seems to be that the Fed will raise its policy interest rate in December. But, as I have discussed, there doesn't seem to be any strong belief that the Fed will do much more than that in 2017, even though Federal Reserve projections show that Fed officials are forecasting the Federal Funds rate to average 1.1 percent during the year. This is up from the current effective Federal Funds rate of around 40 basis points.

Some analysts are arguing that the reason for the rise in rates can be pointed at Mark Carney, the Governor of the Bank of England. Mr. Carney is struggling against the possibility of an economic downturn in Great Britain due to the British exit of the European Union.

Last Friday, Mr. Carney indicated that he was willing to accept a rate of inflation in the UK that was modestly above the target rate of the Bank of England. This sent the price of government bonds in a downward direction. The prices of the British government bonds had been retreating any way, and Friday's talk just added to the move.

At the end of September, the yield on the 10-year British government security was around 70 basis points. The day before Mr. Carney's speech, these securities were yielding just over 100 basis points. On Monday, the yield rose to 113 basis points before closing today at 109 basis points.

Later in the day on Friday, Federal Reserve chair Janet Yellen discussed how hard it was in this environment to justify a rise in its policy interest rate. She gave indications that it would be easier to make such a move it there were more market pressures in the economy.

Financial markets took this to mean that Ms. Yellen would like to have a little more inflation going on in the US economy. And, this has been given as a reason for this week's rise in longer-term Treasury yields.

But, like the situation in Great Britain, the yield on the 10-year Treasury had been rising since the end of September.

Mr. Carney voiced his willingness to accept a higher rate of inflation in the face of a declining value of the British pound.

The value of the pound has dropped since the Brexit vote, but after a short period of stability in September, the pound fell in value again towards the end of September. In the last week of September, it took $1.30 to buy one British pound. Then Prime Minister Theresa May spoke about how she was handling a "hard" Brexit and foreign exchange markets went hyper.

At the end of last week, it took less than $1.22 to purchase one pound, before closing at around $1.23 on Tuesday.

So, the drop in the value of the pound coincided with the market's loss of confidence in the direction Ms. May was taking in the move to exit the EU. As a consequence of this loss of confidence, promises were made to support the economy of the UK, both in terms of fiscal policy and, as with the speech of Mr. Carney indicated, with monetary policy.

The possibility of inflation rose once again in Great Britain, causing bond prices to fall and interest rates to rise. And, not only did they fall in Great Britain, they also fell in the United States…and in Germany.

In the last week of September, the yield on the 10-year German bond rested around a negative 12 basis points. This yield rose to a positive 7 basis points before closing on Tuesday to yield 5 basis points.

Thus, it seems that the cause of this latest bump in bond yields was kicked off by the speech of Prime Minister May in Great Britain and then spread through foreign exchange markets and then into bond markets, impacting some of the major economies in the United States and Europe.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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