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Inflation expectations -- another V-sign

This chart shows the breakeven inflation rate for 10-year TIPS (aka the market's 10-year expected inflation rate). It's simply the difference between the nominal yield on 10-year Treasuries and the real yield on 10-year TIPS. As should be obvious, after collapsing last year, inflation expectations have rocketed higher this year for a rather spectacular comeback. Inflation expectations haven't completely returned to the levels they were registering several years ago, but at this rate it won't take much longer to get there.

In one sense, however, inflation expectations are already breaking out to new highs, as shown in this next chart. It's the market's 5-year inflation expectation 5 years forward, as calculated by Barclays. It's now as high as it has ever been, with the brief and tiny exception of Mar. '08, and it looks like it's headed higher. In the annals of inflation, this past year—in which inflation expectations collapsed to zero only to fully rebound 12 months later—will undoubtedly go down as one of the great deflation head-fakes in financial history.

I can't resist referring back to my posts of late last year, in particular this one, in which I argued that "TIPS are a steal" because the market was projecting zero inflation but the Fed was hell-bent on reflating. If I were running the Fed, my message to fellow governors would be "OK, guys, job done: inflation expectations are back on track, now we need to get interest rates back on track."

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