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Inflation expectations are alive, well, and rising

I'm watching the yield curve and TIPS' implied inflation expectations carefully these days. As I've noted several times in the past several weeks, the pronounced steepening of the yield curve at the long end (blue line in this chart) has correlated pretty well with a significant increase in the market's future inflation expectations (red line). Forward-looking inflation expectations have increased from 2% a year at the end of August to almost 3% today. The only time in the past 5 years that we have had a similar-size increase in inflation expectations over a short period was early last year, when the market began to realize that the economy was not falling into a depression/deflation abyss.

The Fed is pulling down Treasury yields out to 10 years, but the Fed has no control over yields beyond that. The increased (and record-setting) spread between 10 and 30 years reflects a market that is balking. The prospect of another round of quantitative easing has convinced the market that inflation is headed higher, much as the Fed now seems to want. Investors are shunning long-term bonds because they are increasingly worried about long-term inflation risks.

This is not good, of course, and that's why the dollar is down since the end of August, and gold is up. Stocks are not getting hit, however, but I think that can be explained if you assume (as I do) that stocks have been depressed for a long time over the risks of a double-dip recession, deflation, and a punishing increase in future tax burdens. The double-dip has so far failed to show up, QE2 all but erases the possibilities of deflation, and the November elections increasingly promise to result in a reduction in government spending and future tax burdens. The combination of all three means that future after-tax cash flows are now expected to be stronger than the market had been thinking. That's why stocks are rallying even though the inflation fundamentals are deteriorating.

UPDATE: Of course, the more inflation expectations rise, the less likely we are to see the Fed proceed with its QE2 program. We've already heard more than one Fed governor say that QE2 is not yet a done deal. I still think there's an outside chance that the Fed does little or nothing in the way of QE2 after next months' FOMC meeting. Though that might be a disappointment to the market at first, any selloff should be viewed as a buying opportunity. It's never a bad thing for the Fed to do the right thing.

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