Forecasting Inflation: What Affects TIPS?

Next, let's take a look at 10-year swap spreads, last discussed here in December 2007 in the context of a negative outlook for corporate bonds. These spreads, plotted inversely below, have been compressed recently by the flight-to-quality into 10-year Treasuries, but have been on a secular rise since the mid-2003 low in interest rates. Plus, these spreads lead TIPS breakevens by 18 months on average; rising swap spreads today should keep TIPS breakevens 18 months from now under pressure.

TIPS' Breakeven Leveled With Swap Spreads

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Source: Bloomberg

What, in turn, pushes swap spreads higher? A steeper yield curve and rising bond volatility -- both of which are present, given the Federal Reserve's recent slapdash approach to monetary policy -- do.

Here is the paradox. Inflation is a monetary phenomenon, and we are in a looser monetary environment, but the Federal Reserve's policies are producing both a flatter money-market yield curve and rising swap spreads, and these, in turn, push inflation expectations lower.

So when you look at those low TIPS breakevens, do not think the market is nuts. It has outperformed the collective forecasting skills of the nation's economists (insert your own joke here), and it reflects powerful financial variables while ignoring rising physical commodity prices.

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