Gavekal Capital: TIPS And Inflation Reality

Friday, January 17, 2014

TIPS And Inflation Reality

By decomposing a US Treasury bond, we can get a sense of the market's expectations for real rates and inflation expectations.  The inflation component is easy to flesh out by just subtracting the TIPS yield, for the same maturity, from the nominal bond interest rate.  From there, we can compare the implied breakeven inflation rate embedded in long bonds to actual measures of inflation.

When we do this exercise currently, we are left feeling that the interest rate on 10-year bonds could fall materially simply due to a re-evaluation of inflation expectations.  Historically the breakeven inflation rate has closely mirrored actual inflation as measured by the CPI or personal consumption expenditures (PCE) index.
Currently, by either measure, inflation expectations are roughly 75bps above the rate of actual inflation.  This suggests to us that investors are anticipating a strongly rising inflation rate.  Should this expectation change, the breakeven inflation rate has lots of room to fall, leading to rates on the nominal 10-year bond falling in tandem.