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Inflation expectations continue to rise

Here's an interesting chart that strongly suggests that 10-year Treasury yields will be trending higher. The blue line is the 5-year, 5-year forward breakeven inflation rate as calculated by Barclays and as reported by Bloomberg. It's a way of extracting future inflation expectations by looking at the relationship between nominal and real Treasury yields along the yield curve. The blue line shows a tendency to lead the red line, which is another way of saying that the T-bond market is a little slow to pick up on underlying inflation fundamentals. Inflation expectations, as embodied in the breakeven spreads of TIPS—as well as gold and commodity prices—are rising. Treasury yields are perhaps being suppressed by Fed purchases of Treasuries and MBS, but I don't feel comfortable making that argument. I think it's just a case of the bond market being slow to the party as usual.

The blue line is something to watch very closely (especially now that it is within 8 bps of a multi-year high) since the Fed has said many times that this is its preferred measure of the market's inflation expectations, and the FOMC recently cited inflation expectations as one of the key indicators they will be watching for signs of whether or not they should tighten monetary policy. If inflation expectations continue to rise, the chances of a tightening will increase significantly, even though it will take a long time for the other indicators the FOMC cited (resource utilization and actual inflation) to sound alarms. Resource allocation (aka economic slack) and actual inflation are notoriously lagging indicators.

Full disclosure: I remain long TBT and short a 30-yr. fixed-rate mortgage at the time of this writing.

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