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Where’s The Inflation?
Written by Paul Amery   
June 03, 2010 19:29 (CET)

According to NSX data, the iShares Barclays TIPS ETF (NYSE Arca: TIP) is now the seventh-largest ETF in the US, with over US$20 billion in assets. Its US$4 billion inflows in 2009 were topped only by the SPRD Gold ETF (NYSE Arca: GLD) and the iShares iBoxx Investment Grade Corporate Bond ETF (NYSE Arca: LQD). In 2010 TIP’s net new cash flows have so far been exceeded only by those same two funds and the US Oil Fund (NYSE Arca: USO).

However, if you look at the breakeven inflation rates implied by the relationship between inflation-linked and fixed-rate bonds, there’s little sign of inflation expectations changing for the worse.

The following charts, taken from Barclays Capital’s “Linker Index Monthly”, show that in the US and the UK longer-dated breakeven inflation rates are little changed from a year ago. There has even been a quite notable decline in breakeven rates during the last couple of months, implying outperformance by fixed-rate bonds over their inflation-linked counterparts.

Breakeven_inflation_-_US

Breakeven_inflation_-_UK

And in Japan, while breakeven rates have been rising over the last year, implying outperformance by inflation-linked bonds, the trend has recently gone into reverse. It’s also worth pointing out that the 10-year breakeven rate still discounts average deflation of over 1% a year for that period.

Breakeven_inflation_-_Japan

So while the world’s monetary authorities are still pump-priming, with the Fed nearly trebling its balance sheet size between October 2008 and today, there’s little sign as yet of this feeding through into higher inflation expectations.

In fact, broader measures of US money supply suggest that we might well be heading in the opposite direction, towards deflation. All evidence suggests that the private sector is deleveraging at a far greater pace than that at which the central bank has been adding funds. According to economist Tim Congdon, quoted in the Daily Telegraph last week, the M3 money supply is falling at a near double-digit annual rate, something which hasn’t been seen since the great depression of the 1930s.

ETF investors in TIPS, whose heavy purchases over the last year reflect a belief that inflation is about to pick up in a major way, must be hoping that the trend Congdon highlights is going to reverse – and soon. You wouldn’t want to be holding TIPS if inflation indices actually fall – you’d be hit by a double-whammy of a declining index level and, presumably, rising real yields to reflect concerns over the issuer’s solvency.

 

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