What Are Interest Rates Telling Us? Part II

Last Updated Nov 28, 2009 3:53 PM EST

Link to Part I
Link to Part III
Topping many economists' list of worries is the potential for inflation in the U.S., as well as in the many other countries that force-fed their banks with capital and other assistance. So far, however, it's just a notion: there are ways to read such things directly in interest rates, and fears of inflation aren't showing up in the market.

Until about 15 years ago, when the U.S. Treasury started to issue inflation-linked bonds (known as TIPS), analysts had to guess at the financial markets' expectation by unscrambling the several components nominal bond yields. At the core of Treasury rates is a natural rate of interest, a sort of Newtonian theoretical rate a lender would charge if inflation and other uncertainties didn't exist.

On top of that natural rate lenders add premiums for expected inflation, expected credit loss, and expected political risk, among others. In the case of the last two, U.S. Treasury bonds are traditionally thought of as free from credit and political risk.

With nominal bonds, investors add to the yield the rate of inflation they expect over the bond's term, in order to preserve the purchasing power of the principal they lend. The challenge comes in knowing what premium will be adequate to cover inflation five or ten years in the future.

But now we have inflation linked bonds, where the Treasury pays a low coupon rate, but increases the principal by the annual change in the CPI. By comparing their yields with those on nominal Treasuries, we can suss out a simple measure of what level of inflation the financial markets are expecting.

In the graph below, we are looking at the difference since 2003 in yields on "regular" fixed coupon nominal Treasuries and inflation linked bonds. For the moment ignore the crevasse that developed in 2008 and early 2009, and look at today's spreads versus 2003 through 2007.

The average spread for both five and 10 year bonds, which represents the premium for inflation embedded in nominal Treasuries, averaged about 2.3 percent for both maturities. (Actual inflation during that same time averaged a little over three percent, so the market underestimated somewhat.) What is the market's estimate of future inflation today? For five years, it's 1.7 percent, and for 10 years, 2.1 percent. In the view of Mike Pond, bond market watcher at Barclays Capital, inflation expectations, at least as they appear in bonds, have normalized.

Back to that sharp drop in the spread during the credit crisis. It had little to do with inflation expectations, and was driven by supply and demand. In the height of the crisis, investors wanted the safety and liquidity of U.S. Treasuries, and were selling everything else. They were even selling U.S. TIPS, government guarantees notwithstanding, because those markets are fairly small and illiquid.

There is a disconnect, though, between what many smart people are saying about inflation - that all the monetary stimulus of 2009 will eventually be expressed in higher prices - and what we've just seen in yields. Tomorrow we will look at this issue through another lens, that of the markets' view of the creditworthiness of the nations that led the bailout.