Inflation is an expansion in the total supply of money and credit, and deflation is a contraction in the total supply of money and credit. This differs from price inflation and deflation which is what orthodox economic analysis concentrates on. There is a link though, and we shall be examining that in subsequent columns. This article deals with price inflation and deflation.
According to the famous French diplomat Talleyrand, “There is one body that knows more than anybody, and that is everybody.” This quote could be a by-line for technical market analysis because it implies that the most important aspect is working out what the crowd is doing. This doesn’t mean that there is always value in following the crowd (the Elliott Wave Principle teaches us that!), but it does mean that price movements in crowd-driven financial markets can provide an indication of sentiment trends.
One way of measuring the trend in price inflation expectations is by examining the index-linked bond markets. These are bond markets where the returns are linked to future inflation; in the USA, they are called TIPS (Treasury Inflation-Protected Securities). By comparing the yield on an inflation-protected bond to the yield on a non-inflation-protected bond (normal Treasuries), we can get a measurement of the expected price inflation rate. This measurement is known as the “breakeven inflation rate” because it represents the level of inflation where the return on both bonds would be the same (where an investor would breakeven).
So breakeven rates represent an indication of expected future inflation and because they are market-based measurements, where investors are putting their money where their beliefs are, they have extra relevance.
Our chart shows the breakeven rate for USA inflation on 5-year bonds, and therefore represents what the market thinks price inflation will be over the next five years. We can see that inflation expectations peaked in 2005 when America was entering the final phase of a credit binge, in large part directed toward real estate. It took a couple more years for the stock market to top out of course, but the fact that inflation expectations did not accompany those new highs in stocks was a good lead indicator of what was to come. The credit binge preceded the so-called “great financial crisis” of 2008 when, with the breakeven rate moving below zero, price inflation expectations actually turned into price deflation expectations for a few months. It should not go unnoticed that inflation expectations collapsed in the middle of 2008, sinking below the previous 2007 low in August 2008, well before the storm raged, and thus, providing another good lead indicator.
What is really interesting about this chart though is that since 2008, while the stock market has been making new higher highs, inflation expectations have been making a series of lower highs. The mainstream impression is that the stock market and economy have been recovering since 2009 (people call this the “reflation trade”), but inflation expectations have continued to fall. This is somewhat inconsistent.
Economists sometimes refer to periods of a growing economy accompanied by low or stable price inflation as a “Goldilocks” environment (not too hot, not too cold, but just right). We, on the other hand, try to stay away from fairy tales and concentrate on the objective message from the data. This chart tells us that over the last twelve years, inflation expectations have been gradually shrinking. People have been expecting price inflation to be lower and lower. For us, this is evidence that a disinflationary mindset is the modus operandi, and that road eventually leads to an outright deflationary mood. It is a long, slow process, but the forces of deflation are relentless in their persistency.
We may be on the cusp of another lurch lower for price inflation expectations. In March this year, the 5-year breakeven rate failed to move above the 2014 reaction high and has subsequently fallen by 33 basis points to 1.72%. A move below 1.60%, the April 2016 reaction high, would be further evidence that talk of a “reflation trade” is nonsense.