US 10-year Tips breakeven rates are surging, and talk of a revival in inflation expectations is, understandably, doing the rounds.
But we’re not entirely convinced that it is that simple.
For one thing, consider the longer trend:
The top chart shows the 10-year Tips rate (currently at around minus 0.8 per cent) and the bottom chart shows the spread vs the regular 10-year (last seen around 1.8 per cent) — what the so-called breakeven rate is derived from.
Thus the more expensive Tips become relative to conventionals, the greater the expectation of inflation.
On a relative basis Tips are (still) more expensive than Treasuries.
But this time, it’s not really that Tips have become dearer … as was the case under under QE2 …
… but rather that Tips have stayed stable as conventional Treasuries have sold off.
Which means it’s the sell-off in Treasuries not the rush for Tips that’s driving the rise in the breakeven rate.
Now, if you consider — as UBS has previously pointed out — that conventional bonds are constrained by the zero floor in the US — it makes sense that any rise in inflation or deflation expectations would be more freely expressed through the Tips market.
What’s more, in times of uncertainty — like leading up to and following QE3 — it makes even more sense that Tips (which offer both inflation and deflation protection) might stay stable, as Treasuries actually take on the job of marking inflation or deflation sentiment.
Indeed, as the following working paper from the Federal Bank of San Francisco from May reminds us that’s because at some point the deflation floor on Tips begins to kick in:
In addition, TIPS bonds provide some protection against price deﬂation since their principal payments are not permitted to decrease below their original par value. This deﬂation protection option has received limited attention in the literature, most likely since it has not been of much value in the U.S. inﬂationary environment since 1997.
So are we seeing a simple rise in inflation expectations… or a fall in deflation fears?
Or has the Fed, by promising to target the employment rate at any cost, effectively started to wipe the deflation charge off conventional Treasuries?