TIPs - Short-term Expectations of Long-term Inflation ~ Steve Blitz Morning Notes
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Tuesday, July 14, 2009

TIPs - Short-term Expectations of Long-term Inflation

If you are concerned that cheaper dollars, higher energy & commodity prices, huge budget deficits, and the potential for the Fed to mishandle the unwind (their track record for shifting policy early to adjust for the economy is far from exceptional) will yield an average inflation over the next 10 years of more than 2.5% thens TIPs are extraordinarily cheap.

The TIPs market isn't as clever or as forward looking as it is purported to be. The chart below maps out the breakeven inflation rate for 10-year TIPs during this decade. Today, inflation expectations are rising, in effect normalizing towards the 2.5% average that existed between the last recession and this one. Breakeven inflation has, however, drooped of late, along with the green shoots of last spring. Going back to last fall -- average deflation during the next 10 years ? The TIPs market priced it that way. Pricing techincals created some of this, relating to potential loss in the accumulated inflation adjustment. Still, fear is fear and short-sighted panic, justified as it might have been, dramatically altered the market's expectation for inflation in the coming 10 years.

The volatility of the breakevens in the past year shows just how much the market's pricing of 10-year inflation is simply an extension of current economic conditions and not an assessment of long-term inflation risk. Market participants are notably late in recognizing a shift in the inflation environment (see rising inflation in the 1970s and disinflation in the 1980s). For those longer-thinking investors concerned about inflation, and concerned with reason, the TIPs market offers an extraordinary opportunity.

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