Michael Ashton | Nov 03, 2016 12:01AM ET
A persistent phenomenon of the last couple of months has been the rise in inflation expectations, in particular market-based measures. The chart below (source: Bloomberg) shows that 10-year inflation swap quotes are now above 2% for the first time in over a year and up about 25-30bps since the end of summer.
The same chart shows that inflation expectations remain far below the levels of 2014, 2013, and…well, actually the levels since 2004, with the exception of the crisis. This is obviously not a surprise per se, since I’ve been beating the drum for months, nay quarters, that breakevens are too low and TIPS too cheap relative to nominals. But why is this happening now? I can think of five solid reasons that market-based measures of inflation expectations are rising, and likely will continue to rise for some time.
Moreover, as has been exhaustively documented here and elsewhere, these slow-moving measures of persistent inflationary pressures have been rising for more than two years, and have been over the current 2% level of 10-year inflation swaps since 2011. At the same time, inflation expectations have been declining. So why are inflation expectations rising? One answer is that investors are now recognizing the likelihood that the inflation dynamic has changed and inflation is not going to abruptly decelerate any time soon.
When inflation quotes were very low, it may have partly been because investors saw no chance of an inflationary accident. But it is hard to look at what has been happening to inflation over the last couple of years, and the extraordinary monetary policy actions of the last decade, and not conclude that there is a possibility – even a small possibility – of a long upside tail. As with options valuation, even an improbable event can have an important impact on the price, if the significance of the event is large. And any nonzero probability of double-digit inflation should raise the equilibrium price of inflation quotes.
So, why did breakevens rally? Among the other reasons, they rallied because they were ridiculously too low. They’re still ridiculously too low, but not quite as ridiculously too low.
What happens next? Well, I look at that list and I see no reason that TIPS shouldn’t continue to outperform nominal bonds for a while since none of those factors looks to be exhausted. That doesn’t mean TIPS will rally – indeed, real yields are ridiculously low and I don’t love TIPS on their own. But, relative to nominal Treasuries (which impound the same real rate expectation), it’s not even a close call.
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