Predicting the Future Rate of Inflation – May Edition

May 7th, 2012 by

(May 7th, 2012) What does the market say about inflation?

The answer is plenty.

The market thinks that inflation will be under 2.0% (1.62% to be exact) for the next two years, and average a little over 2.21% over the next 10 years. If the market is right, then after you factor in inflation, 2, 5 and 10-year Treasury Bonds will in fact be yielding a NEGATIVE rate of return.

This is crazy right? You’re right this is crazy.

Here is a metaphor that might help.

Let’s say you have a pile of gold. You don’t like any of the investment options available to you. What are you to do? Find a safe place to put the gold. It’s going to cost you some money to keep your gold in a nice big strong safe, but you would rather pay the money for your gold to be safe than to have someone rob you of your gold.  US Treasuries have become that big strong safe.

 

How does the market predict inflation?

It’s called the break even rate. In simple terms, you take the treasury yield and subtract the yield of Treasury Inflation Protected Securities (TIPS) with the corresponding maturity. The value of a TIPS moves up and down with the Consumer Price Index, a measure of inflation. This math provides you with an implied rate of inflation.

From November 25, 2011 through March 16 2012, the implied rate of inflation for the next two years steadily climbed from 1.10% to 2.30% as expectations of an economic recovery increased. However. since March 16, the rate has fallen 0.68% as there has been mixed economic news.

Based on the implied rate of inflation, your return on the 2-year treasury is currently negative 1.37%. In fact your return on AA-Rated corporate bonds would also be negative, by almost 1%.

The real rate of return over 5 years is negative (assuming the market is correct) for both corporate bonds and Treasuries. Only when you get to 10-year maturities does the real return turn positive for Corporate Bonds, though Treasuries still give negative yields.

Years       Implied Inflation Rate     Real Rate of Return on Treasuries
2 Years          1.62%                                    - 1.37%
5 Years          1.96%                                    -1.19%
10 Years        2.21%                                     -0.35%

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