Wednesday, May 26, 2010 0 comments

TIP spread - inflation expecations remain fairly high

Even though bond yields are somewhat low—10-year US bond is yielding a little over 3%—inflation expectations remain quite high IMO. Although not perfect, one of the few market-based measures of inflation expectation is the TIP spread (this is the difference between a "normal" bond and an inflation-indexed bond of same maturity.) The following chart plots the spread as of today (I notice a typo in the title but oh well :| ).

The spread is back to pre-crisis levels, when inflation expectation was running between 2% and 3%.  Looked in isolation, all appears normal.

However, the straight bond's yield is somewhat low. The 10 year bond yield is a little over 3% right now. Since bond investors are extremely sensitive to inflation—coupon is fixed in most cases and bond holders get hurt badly if inflation rises—it does indicate that many market participants aren't too concerned with inflation.

Ignoring the crisis period, the last time the 10 year bond yield came close to the 3% level was in 2003. As some of you may recall, that's when we had the last big deflation scare, which culminated with the FedRes cutting rates to 40-year lows and Ben Bernanke publishing his "helicopter" speech on how to battle deflation. Ironically, the strategies and tactics laid out by Bernanke wasn't used in 2003, when many were expectating deflation; and instead, was put to good use when almost no one was expecting deflation in 2008.

The 2003 deflation scare looks like to have been a misdiagnosis but it's really hard to say. Bernanke's well-received speech, along with Greenspan's strategies, did raise inflation expectations so it's hard to say if they actually avoided the deflationary forces or not.

Anyway, coming to the present, it'll be interesting to see what bond investors do here. A real return of 1% (say 10 year bond yield of 3% and inflation of 2%) is a very low return from a historical point of view. Although wrong for many months now, I'm maintaining my deflationary bias and hence expect the TIP bond yield (i.e. inflation expectation) to fall.

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