Bond Market Action Signals Inflation Dead Ahead

By on October 7, 2010

Scott Grannis has an excellent post on the recent action in the bond market indicating deflation risk is on the wane.

The interesting part of the bond market action, however, is in the TIPS market, where yields have plunged by much more than Treasury yields, and in the long end of the Treasury curve, where the spread between 10 and 30-yr Treasuries has widened to its steepest level ever. Since the end of August, when QE2 expectations started to heat up, 10-yr Treasury yields have declined by 10 bps, whereas 10-yr TIPS real yields have dropped by 50 bps. That’s a 40 bps increase in annual inflation expectations over the next 10 years. Using the more sensitive measure of inflation expectations—the 5-yr, 5-yr forward breakeven rate—inflation expectations have jumped almost 50 bps since the end of August (see top chart). The spread between 10- and 30-yr Treasuries has shot up to a record-breaking high of 127 bps, up from 105 bps at the end of August.

Note in the second chart above how the drop in Treasury yields in late 2008 reflected deflationary fears (with inflation expected to average zero over the subsequent 10 years), whereas the current drop reflects inflationary fears.

So the market is saying that it has little doubt that the Fed will ramp up its quantitative easing efforts, and almost no doubt that this will prove inflationary in the years to come. The plunging dollar and the soaring price of gold fully support this interpretation.

This is the best evidence you can find that deflation risk has evaporated. The question now is not how low inflation will be, it’s how high it will be in the years to come.

Grannis has also posted this nice chart indicating how relatively expensive TIPS are:

Source: Calafia Beach Pundit

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