Senin, 07 Januari 2013

Inflation expectations are rising

For the past 15 months, the inflation expectations embedded in TIPS and Treasury bond prices have been moving higher, most likely in response to the Fed's increasingly accommodative policy stance. 10-yr Treasury yields—already quite unattractive relative to current inflation—are thus at serious risk of moving higher, regardless of the Fed's determination to keep them low. Fortunately, this is not something to worry about.

As this first chart shows, Treasury yields and inflation began to diverge in the latter half of 2011; yields fell as inflation rose, an unusual development that could be explained by the Fed's insistence that the economy was so weak that extremely low short-term interest would be required for at least the next several years.

Treasury yields are now about the same as inflation (roughly 2% each), which means that real yields are essentially zero. As the chart above shows, this is a very unusual condition. Since 1960, the real yield on 10-yr Treasuries has averaged about 2.4%, and real yields on Treasuries have only been below zero for about 8 of the past 52 years. Notably, real yields were negative for a good portion of the 1970s, a period notorious for its accommodative monetary policy and relatively high and rising inflation.

The above chart shows the real yield on 3-mo. T-bills, which is a good proxy for the Fed's effective monetary policy stance: high real yields mean policy is tight, while low or negative real yields mean policy is very easy. Monetary policy has rarely been as accommodative as it is today. If the 1970s are a guide, we should thus expect inflation and inflation expectations to be on the rise today.

The chart above shows Bloomberg's calculation of the "breakeven inflation rate" for 5-yr TIPS and Treasuries. This is effectively the bond market's assumption for what consumer price inflation will average over the next 5 years. (If future inflation equals breakeven inflation, then an investment in TIPS or Treasuries of comparable maturity will deliver the same total return.) As you can see, inflation expectations have risen from a low of 1.4% in September 2011 to just over 2% today.

Of course, it's possible that the bond market could be wrong. As the chart above shows, the bond market sometimes can be very wrong about inflation. This chart is just a longer-term version of the one above it. Note that 5-yr inflation expectations at the end of 2008 were -.78%. In the four years since then, the CPI instead has averaged 2.2%. So the bond market was way underestimating inflation back then, and it could be underestimating future inflation today.

This next chart shows the bond market's expectation for what the CPI will average over the 5-yr period beginning 5 years from now. Forward-looking inflation expectations, by this measure, have risen from a low of 2% in September 2011 to now just over 3%.

This chart shows the market's expectation for what the CPI will average over the next 10 years. It's essentially a combination of the 1st and 3rd charts in this series. By this measure, long-term inflation expectations have risen from a low of 1.7% in September 2011 to 2.5% today. That's not at all unusual, because the CPI has averaged almost 2.5% over the past 10 years. So although the market's antennae have picked up a sense of rising inflation, it's not yet something to be terribly concerned about. Unless, that is,  you own Treasuries that are now promising to deliver negative real returns in coming years. And unless the bond market is once again underestimating future inflation.

This last chart compares 5-yr forward inflation expectations to the level of the S&P 500. Both inflation expectations and equity prices have moved together over the past 15 and also for the past 27 months, which suggests that the Fed's accommodative policy stance at the very least is driving the market's outlook for nominal growth. Both equities and bonds are assuming faster nominal growth—driven by higher inflation.

Going back to the very first chart, it seems clear that 10-yr yields are unusually low relative to current inflation. The rest of the charts make it very clear that inflation expectations are on the rise and that at this point there is no reason to believe that inflation will fall. If the gap in the first chart is unsustainable, and I think it is, then it is thus very likely to close with 10-yr yields moving higher.

Once again, I take this opportunity to repeat that the current very low level of Treasury yields only makes sense if you view them from the perspective of a market that is extremely worried about future economic growth. Investors are so risk-averse and so worried about the future that they are willing to forgo earning a positive real yield—and accept a negative real yield—in exchange for the perceived safety of Treasuries.

The Fed is laying the foundation for higher yields with its accommodative policy stance, since inflation and inflation expectations are unquestionably higher. What will end up delivering higher yields is the return of confidence. As the market overcomes its fears and as risk-aversion declines, Treasury yields will rise; investors will attempt to shift out of Treasuries and into more risky assets, causing relative prices to change. Higher yields will thus be symptomatic of an improving economic outlook and rising investor confidence. They will not therefore pose a threat to the economy, and thus are not something to worry about. The sooner they arrive, the better, in fact. And when they do, we'll likely see higher equity prices to boot.

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