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Bonds are worrying about rising inflation

The bond market has a poor record of anticipating major changes in inflation. Treasury yields lagged the rise in inflation throughout most of the 1970s, with the result that real yields were generally low and even negative during the period, and cheap borrowing costs helped fuel inflation fires. Treasury yields also lagged the decline in inflation we experienced in the 80s and 90s, with the result that real yields were generally high during the period, and expensive borrowing costs helped keep inflation low.

But the bond market is not entirely oblivious to what is going on. As the chart above shows, the breakeven inflation rate embodied in 10-yr TIPS and 10-yr Treasuries now stands at almost 2.6% (i.e., the market is priced to the expectation that the CPI will average about 2.6% per year over the next 10 years). That is substantially higher than the 2.0% average breakeven rate that has prevailed since TIPS were first introduced in 1997, and it is only 18 bps shy of its highest level in 2005, just before the CPI recorded a 4.7% year over year gain. Moreover, TIPS 10-yr breakeven spreads have now risen over 250 bps from close to zero at the end of 2008.

All of this adds up to a fairly dramatic statement about how the Fed's quantitative easing program has not only eliminated deflation risk, but now threatens to raise inflation beyond the relatively low levels we have enjoyed for the past three decades.

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