Bond market still pointing towards deflation

From a macro point of view, story of the year will likely be China (I'll have more on that in the future.) The second biggest story may turn out to be the battle between deflation and inflation. I see a lot of investors betting on the outcome but I personally am very close to neutral, with a tilt towards disinflation/low deflation. One market that has been in the deflation camp for a while now is the bond market. MarketWatch picks off a key bond market indicator--the TIPS break-even--that points to deflation:

While much of December consumer price drop can be chalked up to plunging energy prices at year-end, deflation may not end there. The $530 billion market for Treasury Inflation Protected Securities shows prices are expected to continue dropping for several years as a shrinking economy curtails demand.

"The market is forecasting a deflation scenario for years," said Tim Wilhide, co-manager of the $831-million Hartford Inflation Plus Fund. "Nothing on the horizon says right now that the economy is turning around."

The gap between yields on regular five-year notes and five-year TIPS is negative 0.33 percentage point, suggesting consumer prices will decline 0.33% on average over the next five years. That difference is known as the break-even rate and is considered a signal for what investors expect inflation to be over the life of the debt.

TIPS pay investors a coupon rate plus inflation as measured by the consumer price index.

Shorter-term TIPS are pointing to even more deflation, pricing in a drop of nearly 2% over the next year, Wilhide said.

That's quite a switch from July, when the break-even rate topped two percentage points as oil prices hit their record highs.

Although its prediction capability is nowhere near perfect, the TIPS breakeven is a very important indicator in my eyes. The reason I, as well as some professional investors, value the TIPS breakeven is because it is set by the market. This is not a number that is set by the government or is some estimate by select individuals. If you believe in the free market, the TIPS break-even is as good as it comes. Some may argue that the bond market is manipulated by central banks or hedge funds or whomever, but the bond market is generally too big for that. Recall how many were dismissing the yield curve inversion about 2 years ago and claiming that it was due to foreign central bank influence or various other influences (including Bernanke's savings glut theory.) Well, in the end, regardless of who was manipulating the long end of the yield curve, it was actually a good indicator of a recession.

If TIPS is signalling -0.33% inflation over the next 5 years, there is a high chance that it may come to pass. I don't think one should blindly assume that will happen but should be prepared for it.

Having said all that, there are some who doubt the bond market. Among them is a prominent central banker.

"The break-even is completely unrealistic," said Ellen Safir, chief executive and founder of New Century Advisors. "Nobody is forecasting deflation out for five years when we think of what the government is geared to do to re-inflate the economy."

She thinks return to eventual growth means TIPS are undervalued, because they aren't being discounted to account for any inflation that is sure to come back at some point.

San Francisco Federal Reserve President Janet Yellen on Thursday also said she doubted that TIPS spreads are signaling several years' of falling prices.
"I think you do not get a clear read on inflationary expectations from those spreads because nominal Treasurys, especially short-term nominal Treasurys, are very liquid and TIPS are a lot less liquid," she told reporters after a speech in San Francisco.

We shall see if these two ladies are correct in their dismissal of TIPS break-even. For now, I'm leaning towards mild deflation.