Why Are Inflation Expectations Rising?

By: Michael Ashton | Wed, Nov 2, 2016
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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.

US 10-Year Inflation Swaps

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.

Median Inflation

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.

Frequency of 1-Year Inflation Rates

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.

TIPS Cheapness

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 exhauster. 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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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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