Friday, November 23, 2007

5 Year Inflation Expectations Trend



This chart shows the yield on the five year inflation protected treasury and the yield on its non-inflation protected counterpart. The difference is also shown and represents the inflation expectations over the next five years (for both investments to pay the investor exactly the same).

The starting point is August 20, 2007. That was "credit crunch" day. You would think that credit crunch day would cause a wave of short-term deflationary thinking (think Great Depression). Instead, the market seems to fear Ben Bernanke's technology.

But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. - Ben Bernanke, November 21, 2002

They didn't have such a magical and mystical device during the Great Depression of course. We were still on the gold standard.

It becomes very interesting should the blue line reach zero, since that is the lowest it can possibly go. It also becomes very interesting if the black line meets the red line (meaning the five year treasury market is expected to lose money to inflation even before taxes).



See Also:
Treasury Bill Volatility
Deflation: Making Sure "It" Doesn't Happen Here

Source Data:
FRB: Selected Interest Rates

10 comments:

Anonymous said...

This chart shows the yield on the five year inflation protected treasury and the yield on its non-inflation protected counterpart. The difference is also shown and represents the inflation expectations over the next five years (for both investments to pay the investor exactly the same).

Mark can you explain why the difference is thought to represent inflation expectations

Stagflationary Mark said...

Hi,

Mark can you explain why the difference is thought to represent inflation expectations

The 5-year TIPS pays us an inflation adjusted return. If we buy a 1% TIPS you are really buying something that will yield 1% over the official inflation. If inflation averages 3% over the next 5 years, we will be earning an average of 4% (1% + 3%). If inflation averages 5% over the next 5 years, we will be earning an average of 6% (1% + 5%).

When we purchase a non-inflation protected 5 year treasury, we simply earn a fixed rate. If inflation is low, we do well. If inflation spikes higher, we aren't doing so well.

On 11/21/07, we could choose a 3.4% 5-year fixed rate tresasury or we could choose a 1.11% inflation protected treasury.

Let's say inflation averages 1% over the next five years. We'd average 3.4% on the fixed treasury but we'd only earn 2.11% (1.11% + 1% inflation) on the inflation protected version. Clearly we'd want the fixed rate treasury.

Let's say inflation averages 5% over the next five years. We'd average 3.4% on the fixed treasury but we'd earn 6.11% (1.11% + 5% inflation) on the inflation protected treasury. Clearly we'd want the inflation protected version.

We can't know what the inflation rate will be over the next five years ahead of time, but we can find the breakeven point between the two investments.

Break even point = 3.4% - 1.11% = 2.29%

If inflation averages 2.29% over the next five years we'd earn 3.4% on the fixed treasury and we'd earn 3.4% (1.11% + 2.29%) on the inflation protected treasury. Both investments would yield exactly the same.

2.29% therefore represents the current inflation expectations over the next five years, as determined by the average investor in the treasury market.

Anonymous said...

thanks well explained. I read many of your comments with interest on CR

Stagflationary Mark said...

Thanks tg :)

Anonymous said...

An amateur's addition: to take that nice example a little further, if you are convinced that inflation will be pretty close to 2.29% pa over the next five years and you buy the inflation-protected investment, then you have got almost free insurance against inflation turning out to be higher.

Stagflationary Mark said...

dearieme,

That's correct (for the record, I'm an amateur as well).

Further, if you are wrong and inflation actually ends up being lower you are even better off (just not as well off as those who locked in a fixed interest rate).

You should still root for lower inflation even with inflation protection.

If inflation averages 0% and you earn 1.11% you'll be doing far better than if inflation averages 20% and you earn 21.11%. The taxes on 21.11% would be most painful (and for most people would turn the inflation adjusted return after taxes well into negative territory).

Inflation is bad enough, but the tax on the inflation also does serious damage. You can be inflation protected, but it is very difficult to be tax protected.

Those that were neither inflation protected nor tax protected in the 1970s were in a world of hurt.

Sadly, with so many baby boomers nearing retirement and possibly seeking safety, they might find that very little is safe. This might be especially true if they lock in long-term CDs at their local bank (should inflation pick up).

The investments that have worked since 1980 (with falling inflation) would not necessarily be the ones that would even remotely work if inflation begins to rise.

The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. - Alan Greenspan, 1966

Anonymous said...

Your Greenspan quotation is chilling. I suppose it means that Governments will find a way to renege on their inflation-protected bonds.

Stagflationary Mark said...

dearieme,

The easiest way for the government to renege on their inflation-protected bonds is through inflation, as odd as that sounds.

If inflation is 20%, you are earning 21.11% on your inflation protected bonds, and you are in a 30% tax bracket, you will be losing about 5% of your portfolio to the tax man each year (in real purchasing power).

However, think how much worse it would be if you didn't even have the inflation protection.

I-Bonds wouldn't suffer nearly as much, but the government limits how many I-Bonds you can buy each year (the government can't have everyone protecting all their money from inflation and taxes, as per Greenspan's quote).

The harder way for the government to renege is to simply raise taxes. That would also work of course. It's just less politically popular.

Heaven forbid we get both at the same time: higher inflation AND higher taxes.

The moral of the story is that the welfare state needs its cut in both good times and bad times, and will not be denied.

That's why some say that the goal during a bear market is to simply lose less money. It can be very difficult to hold onto what you have even if you see it coming (I'm not implying that I necessarily do see it coming, but the risks certainly seem much, much higher these days).

Anonymous said...

The yield curve dropped across the board over the recent days. Is the reduction in real and nominal long interest rates merely a repricing of risk? That is, money moving from equities and riskier debt to lower risk debt?

If so, those funds have not yet begun to flow out of the country. Maybe from a foreign investor's perspective the increased pricing in treasuries is about offset by decreased value of the dollar - though I don't know why the two would be related.

Stagflationary Mark said...

Anonymous,

Is the reduction in real and nominal long interest rates merely a repricing of risk? That is, money moving from equities and riskier debt to lower risk debt?

I think that's a lot of it.

I also think some investors (like me perhaps) are starting to realize that high real rates of return are simply not sustainable. The 1980s and 1990s are over but it was fun while it lasted.

I believe we're finally coming to grips with the following. I joked back in September about how even relatively minor exponential growth would someday make my offspring exceedingly rich. It is less of a joke these days of course.

http://illusionofprosperity.blogspot.com/2007/09/exponential-growth-and-immortality.html