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TIPS get a whiff of inflation concerns

The TIPS market is finally beginning to understand that inflation is not going to be unusually low forever. As the first chart shows, the breakeven inflation rate on 10-year TIPS has risen to 2.1%, the highest level we have seen just before the Lehman collapse last year. (This same rate averaged about 2.5% during the 2004-2007 period.) As the second chart shows, the five-year, five-year forward breakeven rate (as calculated by Barclays) has risen to 2.6%, which is in fact a little higher than it was during the 2006-2007 period. Inflation expectations have been slowly working their way higher all year, and it shows up in the combination of declining real yields on TIPS, as demand for TIPS's inflation expectation increases, and rising nominal yields, as demand for unprotected bonds declines.

I've argued many times this past year that the bond market is not the best place to go looking for signs of inflation. That's because the bond market is heavily influenced by what the Fed says and does, and the Fed is not always right about the direction of inflation. Bonds (and the Fed) tend to be late to the inflation or deflation party, and that's one way that inflation or deflation feeds on itself.

So while the bond market's inflation expectations have increased substantially this year, it is not really sending any warning signals about inflation, but rather confirming what objective observers have known for some time: 1) deflation is a total no-show, and 2) inflation as we have known it for the past 10 years is still very much alive and well. Early this year the bond market was convinced that deflation was very likely for the next several years. Now, after watching oil prices almost double over the course of this year, gold prices rise from $875 to $1090/oz., and spot commodity prices rise by one third, the bond market has so far only concluded that it was mistaken about deflation. It has yet to figure out that higher inflation is the thing to worry about. That will be the next shoe to drop.

Full disclosure: I am long TIPS and TIP as of this writing.

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