Charts of the Month.

March '21

We’re trying something a bit different this month with our Charts publication.

Jeff Snider mentioned, as we were working on the last Dollar piece together, that there are economic ‘warning signs’ all over the place, most noticeable in the historically inverted TIPS Yield Curve.

TIPS breakevens, or breakeven inflation rates, are the difference between the nominal and the inflation-adjusted bond yield of the same maturity. In other words, they help us gauge what the implied level of inflation expectation is across different maturities.

Instinctively, you would expect to see inflation (read higher prices) to have a greater impact as you move out the maturity curve; that is, the level of inflation should be higher in the long-term than in the short term. This makes sense in a world in which you would expect to see a certain level of prosperity growth, which pushes the general level of wealth higher, leading to higher prices (to all the PhD in economics out there, we can feel you’re breathing heavier… we’re only simplifying to help contextualize the chart).

The current reality is different though. The above-mentioned measures of inflation expectations inverted in December of last year. The 5-year breakeven is higher than the 10-year, and both of those are also becoming substantially higher than the 5-year/5-year forward inflation rate (which is derived from the breakevens at the 5s and 10s).

Given we hold Jeff in high regard, we wanted to get some thoughts on this chart from a handful of people who are way smarter than us to see if their opinion differed.

So below is what the inversion looks like, and a few points from our guests: Jeff Snider, Luke Gromen, Seth Levine, Tyler Neville, and Roger Hirst.

Jeff Snider | Alhambra Investments

  • Market-based inflation expectations in Treasuries/TIPS, breakevens, are typically 'upward sloping'; that is, the breakeven rate for the 5-year is less than the breakeven rate for the 10-year. Instinctively, that makes sense: one would normally expect higher prices in ten years than in five.
  • Right now, it's the other way around; the 5-year breakeven is a lot higher than the 10-year and the difference has reached historical extremes. Longer run inflation expectations, such as the 5-year/5-year forward rate, haven't really moved all that much.
  • This indicates the market is hedged/positioned only for short-run price pressures (short-term commodities, fiscal spending, etc.), whilst longer-run inflation expectations remain well-anchored in the same disinflationary stance as has been the case for more than half a decade.
  • In summary, the market believes that inflation will be a short-term episode.
Luke Gromen | Forest for the Trees

  • It's unclear to me why the inversion happened in December. Perhaps, that is when it became more apparent that the US was going to pass another big stimulus despite the recovering economy.
  • From a purely mechanical standpoint, the inversion suggests that market participants expect an uptick in inflation in the near/intermediate-term (potentially as a result of US stimulus?), and then a weakening of inflation further out (potentially as a result of Fed hikes?).
  • Alternatively, it seems possible that the inversion is being caused by the Fed having become a major player in TIPS markets in recent quarters (as TIPS markets are otherwise fairly illiquid apparently, meaning that any kind of Fed’s activity would have a significant impact on TIPS prices).
Seth Levine | The Integrating Investor

  • Taken as a fundamental signal, the chart suggests that inflation will be allowed to “run hot” and above the Fed’s 2% target over the near-term [as previously signaled by the Chair anyways] before reverting back to lower levels afterwards.
  • However, these are derivative signals – a comparison of several market prices. Thus, I’m skeptical of the signals’ clarity. Fund flows and technicals can impact prices without regard for fundamentals (i.e. inflation expectations). This could be occurring in the TIPS market; at least it’s hard for me to rule that out.
  • Sure, the market may be expecting a relatively severe increase in CPI growth soon. This is logical considering the amount of fiscal stimulus spending (money in the hands of consumers) and dovish Fed. But also, other factors may be at play (like more nominal UST supply to fund a growing deficit and TIPS technicals).
  • Thus, I’m careful not to read too much into it, especially since I don’t have a good handle on the technical said.
Tyler Neville | Blockworks

  • For years the US government failed to address any problems in the economy using the fiscal toolkit and only relied on the Fed’s monetary policy to keep the economy going.
  • With the Pandemic hurting the economic backdrop and Democrats holding a majority in Congress, it becomes immensely easier to deploy massive fiscal spending.
  • The chart above tells me that the fiscal spending from the Biden administration is going to set off many inflationary impulses over the next five years, but over ten years, the deflationary forces of demographics are even more powerful than any spending we will embark on the fiscal stimulus side.
Roger Hirst | Lykeion & Real Vision

  • The reflation trade is riddled with inconsistencies through both time and geography. True reflation/inflation should impact longer-term inflation expectations to a greater extent than shorter-term expectations and yet, as the chart shows, US 5-year inflation expectations have outperformed 10-year expectations. The spread recently reached its widest level in 20 years (the outperformance of the 5-year versus the 30-year is even more extreme).
  • Furthermore, the spread between US and European inflation expectations has also touched a multi-year wide, in favor of higher expectations in the US versus Europe.
  • This reflation trade is a far cry from the synchronized growth of 2002-2007 and 2016-2018. Today it is concentrated in both time (5-year) and space (US). Was this true reflation? Or was this the outperformance of reflation assets on the back of a weaker USD, bolstered by speculative flows? I believe it’s the latter.
  • The inversion in inflation expectations is a clue that the reflation trade might be a mirage. It would be very painful for the consensus view if this were to reverse.