Inflation: Will It Remain Dormant Or Escalate In Coming Years? (+2K Views)

According to the pricing of TIPS and Treasuries, the bond market has decided that we’re likely to see:

•  inflation returning to around 2% a year in the near future coupled with
• little hope for any meaningful pickup in the outlook for real economic growth.
  

Here’s why:

By Scott Grannis (scottgrannis.blogspot.ca). (The original article*, as posted on said site under the title TIPS say the deflation “threat” has passed, has been abbreviated below to ensure a fast and easy read.)

5-yr Inflation Expectations

The chart below shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market’s expected average annual inflation rate over the next five years. Inflation expectations began to fall last summer, about the same time the oil prices began to decline. They reached a low of 1.2% late last year, and closed today at 1.7% [see UPDATE below].

TIPS Valuation

Even though inflation expectations are back to “normal,” the real yields on TIPS are very low (see chart below). The market is not afraid of inflation being any different than it has been in the past (~2%), but the very low level of real yields (and the correspondingly very high level of TIPS prices) suggests that the bond market holds out very little hope for any meaningful pickup in the outlook for real economic growth.

TIPS are very expensive at these levels. Investors are willing to accept an almost insignificant real yield [see UPDATE below] in exchange for protection against uncertainty. Rather than cheering cheaper energy, the market continues to worry about the lack of growth and opportunity, and is willing to pay up for safety.

Gold vs. Real Yields

This same preference for safety is seen in the chart below which compares the price of gold with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both assets are still trading at fairly high levels from an historical perspective. This suggests that the market is still dominated by pessimism, not optimism. In a very optimistic market environment, the price of gold would be an order of magnitude lower, and the real yield on TIPS would be north of 3%. We are many years away from either.

In spite of the above indications, however, I remain optimistic if only because the market seems to be still so pessimistic. In fact, I’m willing to bet that both growth and inflation will prove higher than expected in the years to come.

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(UPDATE: As of 8:00 am PST 2/27, markets have continued further in the direction of higher inflation expectations: the expected inflation rate for the next five years has increased to 1.8%. The real yield on 5-yr TIPS has fallen to -0.3%, which points to an even more cautious market.)

[The above article is presented by  Lorimer Wilson, editor of  www.munKNEE.com and has been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. This paragraph must be included in any article re-posting to avoid copyright infringement.]

*Source of Original Article: http://scottgrannis.blogspot.ca/2015/02/tips-say-deflation-threat-has-passed.html

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