The minutes of the Federal Reserve’s July meeting will be released Wednesday afternoon and all eyes will be on any hints the central bank will begin tapering its bond purchases.
Indeed, Treasury yields have already spiked on expectations the Fed will begin winding down its economic stimulus in September.
Yet one thing is certain: Inflation expectations are not pushing interest rates higher.
This is apparent in the performance of ETFs tracking Treasury Inflation Protected Securities, and the so-called inflation breakeven rate. [Rising Rates and Low Inflation a Toxic Mix for TIPS ETFs]
The breakeven rate is calculated by comparing yields on TIPS to Treasuries of similar duration. If inflation averages more than the breakeven rate over a given time period, then investors would be better off owning TIPS than normal Treasury bonds. When the rate is rising, it means inflation expectations are rising.
The recent jump in Treasury yields hasn’t corresponded with a significant increase in the inflation breakeven rate.
In fact the bulk of 2013 “has been defined factually by falling inflation expectations,” writes Michael Gayed, chief investment strategist at Pension Partners, in a MarketWatch article. “Indeed, U.S. stocks have ignored this, which is itself largely unusual historically.”
Some investors have warned the Fed’s quantitative easing would stoke runaway inflation, but it hasn’t happened.
The breakeven rate in 10-year TIPS shows that investors expect inflation to rise just over 2% the next decade.
Fed chief Ben Bernanke is “not going to be viewed as the unwitting architect of a ruinous series of price inflation,” said John Lonski, chief economist at Moody’s Capital Markets Research Group, in a Bloomberg report. “I just don’t see that happening, and the TIPS — they don’t see that happening either.”
Low inflation expectations may actually make the Fed more reluctant to begin tapering.
“The Fed minutes are very important, and perhaps some are getting worried that risks are tilted towards a disappointment,” said Kasper Kirkegaard, FX strategist at Danske Bank, in a Reuters report. “Our main scenario is that the Fed will begin tapering in September. If the Fed shows any concerns about low inflation or that they need to see a further improvement in the labor markets before tapering, it could send the dollar lower.”
The chart below shows the relative performance of iShares TIPS ETF (NYSEArca: TIP) against iShares 7-10 Year Treasury ETF (NYSEArca: IEF). The ETFs have similar durations. When the chart is rising, it means inflation expectations are rising.
Full disclosure: Tom Lydon’s clients own TIP.