with gas prices rising and becoming a hot button political issue we wanted to explore the market’s inflation expectations a little deeper. As we pointed out in Gas Prices and the Real Equity Risk Premium market multiples will contract when inflation rises and we believe this represents the main risk to growth and the rally in equities.
Since the financial crisis one of the main objectives of the Fed has been to avoid a deflationary spiral via QE and the inflation discounts in the market have responded when the Fed has the printing press at full throttle which has shown up in a weak dollar, steep yield curve, rising breakeven inflation rates and higher commodity prices. When the Fed announced Operation Twist at the 9/21 meeting we posited that this was, unlike QE, a backdoor defense of the dollar. Clearly Bernanke recognized that the weak dollar’s affect on rising commodity prices was the primary cause of the growth slowdown in the first half of 2011 and thus he needed to keep interest rates low but maintain a balance sheet neutral position to protect the dollar.
you can see in the above chart that when the Fed announced Operation Twist there was a market reaction as the curve steepened, breakeven rates rose, the dollar weakened against the Euro and commodity prices ticked higher. Since the initial reaction these market based inflation discounts have reacted differently. The bond market continued to see the curve steepen with rising inflation discounts as TIPS outperformed nominal bonds in the rally. On the flip side the dollar has continued the strengthening trend since bottoming during the spring, no doubt on EU concerns and an end to QE II and commodity prices ex-oil have remained near the same levels since Operation Twist. We think this divergence is notable.
There are two basic schools of thought on the Fed’s next move. The dovish wing of the Fed which rules the roost led by NY Fed’s Bill Dudley seems to favor further attempts to generate positive inflation as a way to produce higher nominal GDP in order to close the output gap. The more hawkish (if you can call it that) ideas that have been floated, most recently by the WSJ’s Jon Hilsenrath is for a “sterilzed” QE that would like Operation Twist be balance sheet neutral. There is also the possibility they do nothing but Bernanke has found abstinence difficult to practice.
We think the main culprit in the market’s diverging inflation discounts is the recent backup in nominal bond yields with speculators leaning on the long end. If interest rates are rising due to a pick up in real economic growth the dollar should rally and put pressure on commodity prices. If rising interest rates are leading an uptick in inflation expectations you would expect to see the dollar falling with commodities rallying. Thus far it looks like the bond market’s rising inflation discount is due to rising gas prices and the potential trickle down affect on the CPI which TIPS are indexed to and not a more broad repricing of inflation expectations due to anticipation of the printing press. At least not yet.