Biotech Values

[DewDiligence]

For Inflation Tips, Look to '5yr5yr Breakeven'

[This metric is essentially the disparity between 5-year and 10-year TIPS after adjusting each of those rates by the rates on ordinary T-bonds of the same duration.]

http://online.wsj.com/article/SB20001424052748704905604575027572634551574.html

›By TOM LAURICELLA
JANUARY 27, 2010

When the Federal Reserve announces its stance on interest rates Wednesday afternoon, it will likely cite stable longer-term inflation expectations as one reason to keep rates low.

But one key measure watched by the Fed suggests that investors aren't convinced the central bank will successfully reverse its massive infusion of money into markets without sparking inflation.

Treasury inflation-protected securities, or TIPS, indicate investors' inflation expectations practically in real time.

By some measures, TIPS show a tame inflation outlook. Using the difference between yields on regular Treasurys and TIPS—known as a "breakeven" rate—five-year TIPS are priced for the consumer-price index to rise just 1.8% a year until 2015, and 10-year TIPS are priced for inflation to run at a 2.3% annual rate, below the long-term average for CPI.

But swings in food and energy prices can distort inflation readings short term, while a 10-year average can smooth out meaningful inflation signals.

A better reading can come from the "5yr5yr breakeven," which uses implied inflation rates on five-year and 10-year TIPS to calculate inflation expectations in the period five to 10 years down the road.

There are different ways to calculate the 5yr5yr breakeven, but according to a version published by the Fed, inflation is expected to exceed 3% per year.

That figure has been stable for several months. However, it also is at levels last regularly seen in 2003 and 2004, when many say the Fed helped inflate the housing bubble.

Barclays Capital's 5yr5yr measure now reads 2.9%, also on a par with levels in late 2003. Then, "these measures increased because the Fed was keeping rates low" as it's doing now, says Michael Pond, inflation market strategist at Barclays.

What's causing this? Not expectations of rapid economic growth.

"Investors appear to be concerned that the Fed may not have the right tools to put quantitative easing into reverse or get the timing right," says Jeffrey Schoenfeld, co-head of fixed income at Brown Brothers Harriman.

From these levels, when the Fed eventually unveils its exit strategy, a rise in the 5yr5yr could be a signal saying that it isn't going well.‹