Tuesday, April 19, 2011

Inflation Expectation Chaos

I offer two charts for your consideration.

Inflation expectations can be somewhat determined by comparing the yields on 10-year treasuries with inflation protection (TIPS) to those without inflation protection.

Ben Bernanke would have liked nothing more than to simply return to the blue line and restore a sense of normalcy. That deflationary zone in the lower right hand corner is his worst nightmare.

Unfortunately, we had some momentum. We didn't stop when we hit the blue line. We just blew right on past it.

The following chart is something you probably won't see elsewhere. If we determine the inflation expectations for 5 years, 7 years, and 10 years then we can also determine the inflation expectations from 5 to 7 years and from 7 to 10 years.

Inflation expectations from 5 to 7 years: 2.49%
Inflation expectations from 7 to 10 years: 3.38%

When the inflation expectations from 5 to 7 years do not closely match the inflation expectations from 7 to 10 years then I would argue that there is some chaos in the system. There's just no way the bond market can make predictions that far out with such accuracy.

That's nearly a 1% gap. It isn't just because inflation expectations are higher further out. 20 year inflation expectations are 2.84% right now. I seriously doubt that the bond market has figured out that there will be a mini inflation bubble 7 years from now and it will last 3 years. Let's just put it that way.

The danger here would be that inflation expectation gap continues to increase until something breaks again. You can see that (deflationary) break in the chart in late 2008. It is not difficult to spot.

In any event, the inflation expectation chaos that began in 2007 is not over yet. The chart clearly shows it. Perhaps these are merely aftershocks or perhaps we now live on a fault line. I'm tempted to think the latter.

Source Data:
FRB: Selected Interest Rates
US Treasury: Daily Treasury Yield Curve Rates


getyourselfconnected said...

I cannot predict next week, never mind 7 years!

Stagflationary Mark said...


I hear that.

It is like my short-term inflationary mood prediction as seen in the upper left hand corner of this blog.

I might just as well say partly cloudy with a 20% chance of rain. ;)

Mr Slippery said...


Really nice charts. Well done. There is a lot of information there.

I don't think the flaws in the system have been fundamentally fixed, so we are bound to get more chaos sooner or later.

Dave Rosenburg thinks we will get an inflation "scare" over the next couple of months, then it will settle down again. This is what the Fed is saying as well.

I can see it playing out like that if QE2 is not followed by QE3 and there is no new fiscal stim. The politics sure smell like austerity is in the air.

Gold is acting like a lot of inflation is coming. Silver is acting like a monetary metal in short supply. I have been selling some physical silver into the front side of the parabola.

I bought some corp bonds today at 5.12% YTM to better position for some 2nd half disinflation. My active trading has been weak this year, just under 5% ROI YTD. I should probably give up trading but someone has to put food on my broker's table.

Stagflationary Mark said...

Mr Slippery,

Dave Rosenburg thinks we will get an inflation "scare" over the next couple of months, then it will settle down again. This is what the Fed is saying as well.

That theory seems fairly strong to me. The headline CPI has some room for fright. That's especially true in June's report.

Seasonally adjusted, the CPI was flat from November 2009 to June 2010. The lowest reading since November 2009 was actually in June 2010.

You can see it here.

Jun 2010: 216.865
Mar 2011: 223.490

Even if monthly inflation were to remain flat through June, the headline rate would move up to 3.1%. Any additional monthly increases in April, May, and June would simply add to that number.

If we do get substantial increases in April, May, and June then some might argue that it has been a full year of consecutive monthly substantial increases. That would also add to the fright.

Should be interesting though, one way or another.

Stagflationary Mark said...

As a side note, congrats for having silver to sell at $40+.

I'm such a wimp. The first parabola back in 2006 scraped me off. I got just over $10, lol.

That said, I can hardly complain about making 50% off of the investment.

Stagflationary Mark said...

Here's another glimpse at the confusion in inflation expectations.

5-10 years: 3.02%
10-20 years: 3.05%

Those seem like reasonable predictions. They aren't necessarily accurate, but at least they are consistent.

5-7 years: 2.49%
7-10 years: 3.38%

Those numbers should more closely match if you buy the argument that the inflation expectation curve should be flat that far out.

There is a disturbance in the force. Okay, okay. It might not be quite that bad. Who really knows though? I first saw this behavior in 2007. That's not the kind of history we want to see repeating. What came next was higher than normal inflation followed by a deflationary crash.

October 20, 2007
Inflation Expectations

This chart attempts to estimate inflation at various points in the future. For example, the five to seven year prediction is what the market expects inflation to be in the two years starting five years from now. To come up with this graph I merely took the seven year inflation expectation and removed the five year inflation expectation from it. The remainder was the period from five to seven years.

I find it interesting to see the divergence between the three lines in recent months. Hey you hedge funds! You might want to work on arbitraging those gaps and close them a bit, well, unless you think the market can accurately predict that far out.