There’s a close inverse correlation between the expected inflation rate--as measured by the yield spread between the 10-year Treasury and the comparable TIPS--and the trade-weighted dollar Since the start of the year, expected inflation has been hovering in a range between 2.12% and 2.31%. It dropped significantly in recent weeks to 1.93% yesterday, coinciding with a sharp increase in the dollar. The TIPS yield has edged down recently, but isn’t down as much as expected inflation. In other words, most of the recent decline in the bond yield was attributable to falling inflationary expectations, which may be related to the stronger dollar.
Fed officials keep close watch on inflationary expectations in the TIPS market. Each of the 11 FOMC statements from December 12, 2012 through June 18, 2014 included the following boilerplate language: “longer-term inflation expectations continue to be well anchored.” That assessment is primarily based on the TIPS yield spread.
The TIPS spread suggests that inflationary expectations are no longer well anchored; instead, they are falling sharply. All the more reason to hold off on hiking the federal funds rate.
The question is why is the spread narrowing sharply? Here’s the rub: It may be narrowing because foreign investors are piling into the US bond market, which is why the dollar is strong. Of course, the strong dollar encourages foreigners to pile in some more since that increases their return in their local currencies. The reason they are doing so is because US bond yields well exceed foreign bond yields, especially in Japan and the Eurozone.
But US bond yields have exceeded foreign bond yields in Japan and the Eurozone all year. What’s changed? The drop in those overseas yields relative to US yields has been especially dramatic this year. Foreign investors have become increasingly convinced that the weak performances of the economies of Japan and the Eurozone will force the BOJ and ECB to maintain their ultra-easy monetary policies and provide additional easing measures if necessary.
In other words, the narrowing of the TIPS spread may have nothing to do with inflationary expectations in the US. Rather, the spread is narrowing because foreign investors are reaching for yield in the US. In Japan and the Eurozone, the central banks are seeking to avert deflation. Their efforts to do so are depressing their currencies and narrowing the TIPS spread in the US.
Fed officials might fret that inflationary expectations are declining, and hold off on raising the federal funds rate. That might actually push bond yields in the US still lower, exacerbating the decline in the TIPS market’s presumed measure of inflationary expectation.
Fed officials keep close watch on inflationary expectations in the TIPS market. Each of the 11 FOMC statements from December 12, 2012 through June 18, 2014 included the following boilerplate language: “longer-term inflation expectations continue to be well anchored.” That assessment is primarily based on the TIPS yield spread.
The TIPS spread suggests that inflationary expectations are no longer well anchored; instead, they are falling sharply. All the more reason to hold off on hiking the federal funds rate.
The question is why is the spread narrowing sharply? Here’s the rub: It may be narrowing because foreign investors are piling into the US bond market, which is why the dollar is strong. Of course, the strong dollar encourages foreigners to pile in some more since that increases their return in their local currencies. The reason they are doing so is because US bond yields well exceed foreign bond yields, especially in Japan and the Eurozone.
But US bond yields have exceeded foreign bond yields in Japan and the Eurozone all year. What’s changed? The drop in those overseas yields relative to US yields has been especially dramatic this year. Foreign investors have become increasingly convinced that the weak performances of the economies of Japan and the Eurozone will force the BOJ and ECB to maintain their ultra-easy monetary policies and provide additional easing measures if necessary.
In other words, the narrowing of the TIPS spread may have nothing to do with inflationary expectations in the US. Rather, the spread is narrowing because foreign investors are reaching for yield in the US. In Japan and the Eurozone, the central banks are seeking to avert deflation. Their efforts to do so are depressing their currencies and narrowing the TIPS spread in the US.
Fed officials might fret that inflationary expectations are declining, and hold off on raising the federal funds rate. That might actually push bond yields in the US still lower, exacerbating the decline in the TIPS market’s presumed measure of inflationary expectation.
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