The big question these days around the investment community: Do you adjust your portfolio to hedge against Inflation? or Deflation? or Stagflation? or Disinflation?
Yesterday we took a look at what the Fed Fund Futures were indicating as a possible target date for future rate hikes (I wish there were futures contracts this detailed for the NFL and NBA season start dates). Anyway, yesterday both UBS and Barclays Capital put out notes about their concern with the rise in core inflation pressures. They suggest this recent increase in the core will push the Fed to act sooner than the market expects to tighten policy. As we discussed yesterday, this is not at all what the fed-funds market expects. That market doesn’t expect the first rate increase until the second half of 2012.
It is widely believed that one of the metrics most heavily relied upon by the Fed is the five-year five-year-forward break-even rate. Inflation break-even rates are simply the yield on a Treasury security less the yield on the corresponding Treasury Inflation-Protected Securities. So effectively, if the 10-year Treasury yields 3.00%, and the 10-year TIPS yields 0.70%, then the 10-year inflation break-even is 2.30%. The five-year, five-year-forward break-even rate is calculated from the 10-year break-even rate by removing the compounded effects of the five-year break-even rate, so that we are just left with the last five years of the 10-year break-even rate.
The five-year five-year forward breakeven rate projects what the rate of consumer price increases may be beginning in 2016, smoothing blips in inflation expectations from swings in oil prices and other temporary events.
The 5-year, 5-year forward inflation expectation gauge maintained by the New York Fed, which is a little bit of a cleaner read, has fallen to about 2.7% from almost 3.2% in April. That means TIPS investors expect inflation for the five years starting five years from now will be roughly 2.7%.
This is probably a result of the return of worries about economic growth, which tend to keep a lid on inflation anxiety. This is similar action to what we saw a year ago, when economic growth slowed and TIPS breakevens shrunk dramatically. This was a deflationary signal. It’s not exactly deflationary yet, but the Fed will be keeping an eye on this before striking up the QE3 bandwagon.