Authored by Kevin Muir via The Macro Tourist blog,
I have been banging on the inflation drum for so long I feel that even Todd Rundgren would be sick of hearing from me. While a couple of years ago, the majority of pundits were not talking about inflation - most were focused on the Fed’s inability to create rising prices in anything except financial assets - recently the market has awoken to the risks that accompany a decade of bat-shit-crazy central bank monetary policies.
With the current popularization of warnings about the coming inflation, I don’t know if I can add any value rehashing the points filling financial airwaves. The market seems to have finally caught on.Inflation is coming. In fact, it’s already here. And it will get a lot worse.
Instead of writing yet another piece reiterating my beliefs about why inflation will be a problem in the coming decades, I have decided to explore how market inflation expectations have changed over the past couple of years.
At the start of 2016, the market was pricing in a 1% 5-year breakeven inflation rate. That meant inflation had to average less than 1% for the next five years for nominal bonds to outperform TIPS (Treasury Inflation Protected Securities). Stop and think about that for a moment. The Federal Reserve has an inflation target of 2%. Yet the market did not believe they could achieve an inflation rate of even half their target.
The three Ds (deflation, demographics, and debt) were on everyone’s lips. It made little sense to invest in inflation-protected securities when everyone knew there could be no inflation.
Well, guess what? That 1% 5-year breakeven rate has now risen to 2%.
Today the market is expecting the Federal Reserve to hit its 2% inflation target.
But the most interesting part of this higher repricing of inflation expectations? Instead of worrying about inflation getting away from the Fed, the market is more worried about a short-term spike in inflation than a sustained long-term rise.
To illustrate this, let’s look at the US 2-year and 30-year breakeven inflation rates.
The 2-year breakeven inflation rate has risen from 0% in September 2015 to almost 2% today. During this same period, the 30-year breakeven inflation rate has stayed steady at approximately 2%, finishing that same period about an eighth of a percent higher.
The vast majority of the inflation expectation rise has been centered at the front end of the curve!
Here is another way to think about it. Instead of looking at breakeven inflation rates, let’s look at the yield curve of TIPS securities. This is “real yield” - the rate which an investor will earn after inflation.
Look at the curve two years ago - it was steep with an investor “earning” almost 100 negative basis points at the 1-year term and 75 basis points at the 30-year term....