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Breakeven inflation is the difference between the interest rate on Treasury bonds that are protected against inflation (TIPS) and nominal Treasury bonds, which are not. A breakeven rate is a measure of the inflation compensation an investor would need to receive to make nominal Treasuries equal to inflation protected Treasuries.
Inflation expectations for the five year period beginning in five years have narrowed over the last 3 years. During 2014, market based inflation expectation have trended sharply lower from 2.70% in January to a current level of 2.35%. This precipitous drop in expectations for inflation has broken a well-established 3 year uptrend in breakeven inflation rates (green uptrend line below).
Inflation expectations dropped sharply during the month of August. The 2014 YTD chart below shows rates paid on zero coupon inflation rate swaps for 2 years, 5 years, and 10 years. Many market based measures of inflation expectation are showing very subdued, if not decelerating, inflationary expectations. This economic development not only suggests that the Fed has the flexibility to keep interest rates lower for longer, but it also points to relative strength in the USD, growth in US imports, and steady demand for high dividend paying equities. Furthermore, to the extent that interest rates stay lower for longer, equities are likely to remain relatively more attractive than fixed income.
(Black: 2 Year Zero Coupon Inflation Rate Swap; Green: 5 Year Zero Coupon Inflation Rate Swap; Blue: 10 Year Zero Coupon Inflation Rate Swap)
Tickers: UUP, TIP, TLT, SPY, DVY, DBC, IYR
disclosure: The opinions expressed in this Weekly Chart Book report are those of the author. The materials and commentary are strictly informational and should be used for research use only. This bulletin is not intended to provide investing or other advice or guidance with respect to the matters addressed in the bulletin. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions that comply with matters addressed in this bulletin. Charts and information used in this report are sourced from Bloomberg.