Crazy Spot Curves - Orderly Forwards

By: Michael Ashton | Fri, Jan 30, 2015
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This is an interesting chart I think. It shows the spot CPI swap curve (that is, expected 1y inflation, expected 2y compounded inflation, expected 3y compounded inflation), which is very, very steep at the moment because of the plunge in oil. It also shows the CPI swap curve one year forward (that is, expected inflation for 1y, starting in 1y; expected inflation for 2y, starting in 1y; expected inflation for 3y, starting in 1y - in other words, what the spot curve is expected to look like one year from today). The x-axis is the number of years from now.

Inflation Curves

The spot curve is so steep, it is hard to tell much about the forward curve so here is the forward curve by itself.

1y Forward CPI Curve

Basically, after this oil crash passes through the system, the market thinks inflation will be exactly at 2% (a bit lower than the Fed's target, adjusting for the difference between CPI and PCE, but still amazingly flat) for 6-7 years, and then rise to the heady level of 2.10-2.15% basically forever.

That demonstrates an amazing confidence in the Fed's power. Since inflation tails are longest to the high side, this is equivalent to pricing either no chance of an inflation tail, or that the Fed will consistently miss on the low side by just about exactly the same amount, and that amount happens to be equal to the value of the tail more or less.

But what is really interesting to me is simply how the wild spot curve translates so cleanly to the forward curve, at the moment.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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