Inflation expectations and QE(infinity)

I have posted before regarding inflation expectations in the US treasury market and I need to give you an update, especially so considering the recent round of QE as announced by the Federal Reserve.

A refreshed chart from the Fed of the inflation expectation spread (10 year nominal yield minus 10 year TIPS yield) teases out some interesting items to consider.

10 year nominal Treasuries minus 10 year TIPS (source: Federal Reserve) 

Note how we have recently broke above the 2.5%  Since the GFC it has rarely breached this mark and did not stay there for long.

Now look at when previous QE's were initiated. A graph by dshort.com does the job.

While they are not to the same scale, you will notice the first round of QE was initiated during the deep dark days of the financial crisis.  The inflation expectation spread was near its low of the series and the world looked bleak.

QE2 was discussed mid 2010 and also coincided with an interim dip in the inflation spread at around 1.5%

QE(infinity) was just announced and our inflation expectation spread is already near the highs of the entire series.  

While the Fed and other market participants have their own flavor of inflation expectations they look at this series is near its highs. Before the GFC this spread didn't venture much higher and the Fed thinks they can get it higher now? The future is subject to change (of course) but unless we get some serious wage growth it appears to me the Fed is pushing up against a long term inflation expectation wall.  

As an example here's nominal Personal Consumption Expenditures.  It has been on a secular decline since the inflation days of the 80's and also notice how it recently peaked and appears to be rolling over again (ahem)

Nominal PCE - Source Federal Reserve

For some additional context here's the 10 year nominal and TIPS yield since 2004. Notice how now 10 year TIPS are now going for a negative real yield.

Disclosure: Considering selling/shortening duration on some TIPS positions

Inflation expectations in the bond market

Here's an update on inflation expectations as expressed by the bond market.   As the nominal 10 year yield continues to drop it has pushed the TIPS real yield to nearly zero.  Some investors may grouse at the option of buying a security that guarantees a zero real return for the next 10 years and I agree with their sentiments. 


As to why this situation exists I would suggest it is a result of the Fed's desire to reflate the economy by numerous unconventional means (zero short rates, all the various flavors of QE)  


The spread between nominal and real yields has remains remarkably stable near the 2% mark with some noise on either side.   If we have another financial crisis, this time in Europe, I wonder if we'll see another drop in the implied breakeven rate....

Can the long bond go further?

The recent drop in long term yields is impressive and historic.  While the 30 year treasury yield has backed up a bit it is still very low, currently in the range seen during the depth of the financial crisis of 2008.

I'm not trying to convince you of whether it can go lower in this post even though I currently own long term treasuries. I'm considering selling of some of my position and this blog post is part of me thinking aloud about the situation.

What is interesting about this current phase of declining interest rates is how the 10 year has broken new lows while the 30 year, while low, is not in record territory yet.  (Note the 30 year was not issued for part of the 2000's. You'll see gaps in the data during that period)

30 and 10 year yields

Looking at the difference between 30 and 10 year yields provides a very different picture.

30 year less 10 year yield

While the spread has declined recently we are still in rare territory when the difference between the 30 and 10 is greater than 1%.  What this all means I honestly don't know yet but I thought I'd share with you yet another example of  how our unique our current situation is.

The author owns long term treasuries and is considering paring back his position.

Inflation expectations in the bond market

Here's an update on inflation expectations as expressed by the bond market.   While much is being said right now about inflation expectations becoming unglued the 10 year [Treasury - TIP] difference is not showing anything exceptional yet.   As you can see from the chart inflation expectations (as expressed by nominal yields - 'real' TIPS yields) are getting back to their 'normal' range of around 2.5 percent.

10 year TIP yields are near the low end of the range but some of that is due to nominal yields slowly dropping over time, pushing the TIPS yields down so the difference remains relatively constant.  With QE2 slated to end and oil prices (as well as other base commodities) rising it will be interesting to see if the implied breakeven inflation rate rises above long term resistance of ~2.6 percent.

Inflation expectations

The recent rumors of an imminent second round of quantitative easing (QE 2.0) by the US Federal Reserve has sent ripples throughout the entire financial market.  One series I occasionally check in on is the implied breakeven inflation rate by looking at nominal versus inflation protected rates in the treasury market.    The threat of QE 2.0 can be seen here as well.

Source: Federal Reserve

10 year inflation protected rates (TIPS) have fallen to levels not seen for this entire data series.  In other words people are bidding up the value of inflation protection.    However in the context of comparing TIPS rates to nominal the spread is trending downwards but is not out of the ordinary. 

Interesting. 
Of course the Fed threatening to buy up outstanding T bonds (instead of just buying more at auction) also creates a supply demand issue but this trending divergence bears watching.

Inflation expectations and the Treasury market

Here's your TIP / Treasury market update.  Nothing extraordinary has happened in the Treasury / TIP market in the last few months.  As mentioned in my last entry the easy money has been made and now it is a lot harder (Tips v. nominals)

One item of note is the real TIPS yield is still relatively low as compared to the history of this data series with the last entry being a 1.42% real yield.  Not very exciting, eh?  The 10 year breakeven inflation rate is effectively where it was two years ago before the Financial panic hit (2.27%) 

Inflation expectations in the Treasury market

Relative to nominal treasuries, TIPS were a raging buy at the beginning of 2009 (I bought some then for income clients) Since then the ratio has begun to close in on its apparant long term average around 2.50 (eyeball average)

Note how steady the implied breakeven rate has been since ~2003 excepting the crisis of late 2008 - early 2009.   With the current great debate raging between the inflationists and deflationists it is interesting to now how much this indicator has not moved, and is actually returning to a long run average. 

Inflation expectations in the bond market

While gold continues powering upwards the US Treasury market is not confirming similiar concerns about inflation.  (If gold is climbing due to uncertainty regarding the entire paper fractional banking monetary system is another matter)  Looking at the comparative yields of nominal versus inflation protected bonds (called TIPS) issued by the US treasury is illuminating. 

As you can see inflation expectations in this market are actually lower now than before this crisis erupted in 2008.  If the bond market was truely concerned with inflation you would see the implied breakeven inflation rate go up, not down.