Chart of the Week: Bond Traders Expect Lower Inflation

Jeffrey DeMaso

Portfolio Manager

Most of us are concerned about how long inflation will remain elevated. But the Fed’s army of Ph.D.s hasn’t had much success trying to forecast its rise or fall.

In the absence of a solid model for predicting inflation, I like to keep an eye on the difference between the yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. on Treasury bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. and Treasury Inflation-Protected Securities (TIPS). (As a refresher, TIPS are securities that adjust their principle with inflation—if inflation goes up, your principle goes up and vice versa on the downside. This means that comparing the yields on Treasury bonds and TIPS with similar maturities can be used as an estimate of investors’ inflation expectations.)

For example, on July 7, the five-year Treasury bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. yielded 3.04% while the five-year TIPS yielded 0.51%. Some simple subtraction shows the bond market was pricing in inflation of 2.53% per year over the next five years. That’s a good deal lower than the recent over-8% consumer price index reading and much closer to the Federal Reserve’s target inflation rate of 2%.

So, at least in the eyes of bond traders, inflation may come way, way down over the next five years. According to the Atlanta Fed, sticky-price inflation (or inflation of goods for which prices don’t change very often) clocked in at a little over 5% over the past year.

Only time will tell if the bond market’s five-year expectation proves accurate. But the U.S. bond market, accounting for roughly $18 trillion in investor dollars, is a place where a lot of people have a lot of money on the line—ample incentive to get this right.