Michael Ashton | Feb 02, 2018 12:10AM ET
It’s time to get a little wonky on inflation.
Recently, I saw a chart that illustrated that 5-year, 5-year forward inflation – “what the Fed watches” – had recently risen to multi-year highs. While a true statement, that chart obscures a couple of important facts that are either useful, or interesting, or both. Although probably just interesting.
First, the fact that 5-year, 5-year forward inflation (for the non-bond people out there, this is the rate that is implied from the market for 5-year inflation expectations starting 5 years from now) has recently gone to new highs is interesting, but 5-year-5-year breakevens are still at only 2.20% or so.
Historically, the Fed has been comfortable with forward inflation (from breakevens) around 2.50%-2.75% even though its own target is 2% on core PCE (which works out to be something like 2.25%-2.35% on core CPI). That’s because yield curves are typically upward-sloping; in particular, inflation risk ought to trade with a forward premium because the inflation process exhibits momentum and so inflation has long tails.
Ergo, long-dated inflation protection is much more valuable than shorter-dated inflation protection, not just because there is more uncertainty about the future, but because the value of that option increases with time-to-maturity just like any option…but actually moreso since inflation is not naturally mean-reverting, unlike most financial products on which options are struck.
[As an aside, the fact that longer-term inflation protection is much more valuable than shorter-term inflation protection is one of the reasons it is so curious that the Treasury keeps wanting to add to the supply of 5-year TIPS, as it just announced it intends to do, even though the 5-year auction is usually the worst TIPS auction because not many people really care about 5 year inflation. On the other hand, 10-year TIPS auctions usually do pretty well and 30-year TIPS auctions often stop through the screens, because that’s very valuable protection and there isn’t enough of it.]
A second interesting point about 5-year-5-year inflation is that it is only at recent highs if you measure it with breakevens. If you measure it with inflation swaps, forward inflation is still 10bps or so short of the 2016 highs (see chart, source Bloomberg and Enduring Investments calculations).
This chart also illustrates something else that is really important: actual 5-year-5-year forward inflation expectations are up around 2.40%, not down at 2.20%. Inflation swaps are a much better way to measure inflation expectations because they do not suffer from some of the big problems that bond-based breakevens have. For example:
This is all a very windy way to say this: ignore 5-year-5-year forward breakevens and focus on 5-year-5-year forward inflation swaps. Historically the Fed is comfortable with that up around 2.75%-3.25%, although that’s probably partly because they are iffy on bond math. In any case, there is nothing the slightest bit alarming about the current level of forward inflation expectations; indeed, central bankers had much more cause to be alarmed when forward inflation expectations were down around 1.50% – implying that investors had no confidence that the Fed could get within 50bps of its own stated target when given half a decade to do it – than where they are now.
But check with me again in 50bps!
much more widely read article by Fleckenstein, Longstaff, and Lustig. But the bottom line is that as the Dothraki say, ‘it is known.’
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