__flation Update

Gold appears to be undergoing a correction.  Bond yields are very low.  Our clients are still very concerned about inflation.  What’s up?

The chart below features the breakeven inflation rate for the 10-year TIPS (Treasury Inflation Protected Securities).  TIPS are issued by the Treasury and feature a monthly inflation compensation based on the headline Consumer Price Index.  The breakeven inflation rate is determined by subtracting the yield on the TIPS from the Nominal 10-year; that is, the 10-year that is a straight coupon bond with no inflation compensation.  Presently, inflation over the next ten years, based on this measure, is expected to be 1.70% per year.  You can disagree with that–I certainly do–but if that were out of line with the consensus on inflation, market participants would step into arbitrage away the excess/deficit.  So, at any point in time it’s a marked-to-market estimate of inflation.  The TIPS is less liquid than the nominal bond so probably a few basis points of illiquidity are priced in.

For now the trend is–as Dennis Gartman might say–from upper left to lower right.  There have been a series of lower lows, lower highs, and a cross in the moving averages.  The only thing in this picture that points to an upward trend is the upward-sloping 200-day moving average.  The weight of the evidence in this daily-traded inflation gauge is almost unequivocal:  deflation is the risk over the next ten years; not inflation.

Here is a look at the same chart with the price of gold added.  Presently, gold seems to be most popular as a way of expressing a bet that fiat (by decree only) currencies are in trouble, but there is clearly a connection between gold and implied inflation.  To the extent that gold is a way to also express a bet on inflation (without inflation gold isn’t needed as a store of value and vice versa), it looks like gold has a ways to go down to catch up.

Let’s now take a look at the inflation implied in the Treasury yield curve.  As you can see from the chart below, a yield curve plots yields and maturities.  The curve is generally sloping to reflect the higher uncertainty that goes along with longer time frames.  There are several unknowns about the future as it relates to U.S. Treasuries.  There is the possibility that the U.S. might default on its obligations–very small risk–and there’s the possibility that inflation might pop up.  As a consequence, investors expect higher yields.  In the first case (default) they want compensation for the risk.  In the second case (inflation) they want some compensation that their coupon payment received in, say, five years is compensation for inflation.

Now, it’s possible to determine the compensation that investors require to invest in a 10-year over a 2-year Treasury.  (There’s also a monetary policy factor built into the curve, too, as the 2-year Treasury is considered a proxy for the Federal Funds rate.)  The next chart depicts the inflation/default premium.

The chart shows the difference in yields between the 2-year Treasury and the 30-year (top panel), the 10-year (middle panle), and the 5-year (lower panel).

All three are showing lower inflation/default premiums as each is back to 2009 levels.

My conclusion is that gold is heading lower for now.  The market’s conclusion is that inflation isn’t a worry.  The two make sense together.


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