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Call Off the Deflation Warning

Today’s column is a brief one, as I need to post a correction. Not a correction to my stuff, mind you, but to others.

Pictures like the below have been circulating now for a couple of weeks. This is a chart of the 2-year inflation “breakeven” on Bloomberg, illustrating how a “deflation warning” is sounding as they go negative.


Unfortunately, it ain’t so. I wrote to the authors of the original Bloomberg piece referenced above, and called Bloomberg (more on that later), and figured that when I pointed out that 2-year inflation expectations are nowhere near zero, the story would at least die quietly even if pride prevented a retraction. Unfortunately, that hasn’t happened and other “analysts” and news outlets have picked up the story. So, I need to print a correction for them. Unconventional, I know, but I stand for Truth.

The simple fact is that 2-year inflation expectations have fallen deeply, but remain well above zero. The chart below, also from Bloomberg, shows 2-year inflation swaps over the same period. You will notice that it has fallen mightily but remains at about 0.70%.


It turns out that the difference between the Jan-17 TIPS (which have 2 years to maturity) and the Jan-17 nominal Treasuries that are their comparator bond – taking the difference between real and nominal rates gives you the “breakeven” inflation rate that makes them equivalent investments; thus the name – is also about 0.70%.

So why does Bloomberg say the 2-year breakeven is negative? Well, Bloomberg’s “policy” is to track the April-2016 TIPS as the “2-year” TIPS until the new April-2020 TIPS are auctioned in April At that time, they will roll to using the April-2017 TIPS, which will have two years to maturity, and will use that bond for a year. While I applaud Bloomberg for having a policy, that’s no excuse for a stupid policy. There is no place in this universe where the April-16s are a 2-year note. Not even close. And not the “best we can do.”

In truth, especially for short-dated inflation expectations there is no reason not to use inflation swaps. The 2-year inflation swap is evergreen each day with a new 2-year maturity, and there are no idiosyncrasies (such as the fact that the April issues often trade cheap because of the bad seasonality associated with them, so they will usually understate true inflation expectations if you use them) to worry about.

So the story is false. The market is not discounting two years of deflation. Indeed, the reality is quite a bit different. The chart below (source: Enduring Investments – we know stuff like this) shows the 1-year inflation rate, starting 1 year from now (the 1y1y or 1×2 if you like), derived from CPI swaps. While it has come down substantially since the summer, it is not particularly out of line. In fact, it’s pretty much right where core inflation is, which makes sense: the energy spike lower is not going to continue year after year, which means that once it stops then headline inflation will return to the neighborhood of core…unless there’s a rebound in gasoline, of course. But the point is that the best guess of inflation one year from now has little to do with gasoline.

1y1yswapActually, the even-deeper point is that it is appalling how little general knowledge there is about inflation, and how journalists and even many analysts have scant idea how to get to the real story. (Hint: calling an inflation expert is a good start.)

  1. Michael Avallone
    January 7, 2015 at 5:18 pm

    nice catch mike. I gone thru similar stuff with bbg in the past:)

    Sent from my iPhone


  2. Eric
    January 7, 2015 at 6:43 pm

    “There is no place in this universe where the April-16s are a 2-year note.” Heh heh. There actually is: any place that happens to be, if you choose the right space-like hypersurface (which is a conventional choice), simultaneous with April 2014 here on earth. Somehow I don’t think that’s what Bloomberg had in mind.

    Seriously, though: i saw that chart and knew it had to be wrong but didnt know the explanation. Thanks for sharing.

    • January 7, 2015 at 6:57 pm

      Lol..actually I knew when I wrote that line that SOMEONE would go all Star-Trek on me. 🙂 Right you are!

  3. Eric
    January 7, 2015 at 7:05 pm

    More serious question: is it even possible for two year IEs to go negative? To do so, the real yield on 2 year TIPS would have to be higher than the nominal yield on ordinary 2 years. But why would anyone buy the nominal bonds, even if they expected deflation, since TIPS are guaranteed to pay back full face value, even if CPI is negative over the life of the bond. I would think IEs could only be negative for odd periods of time, when the only existing TIPS might have accrued CPI which the investor could lose if there was deflation over the remaining period. Or am I missing something?

    • January 7, 2015 at 9:22 pm

      You’re missing one thing but don’t feel bad because it’s pretty complex. You in fact deserve congratulations for understanding the notion of the out-of-the-money deflation floor! For 2-year TIPS, this is a significant issue because there are no original-issue 2-year TIPS. 2y TIPS have about 18% accretion (if they’re using the 1/17s or 7/16s, both of which are old 10-year notes) or 4.7% (if they’re using the 4/17s, which is an old 5-year note). So that’s a pretty important what-if.

      That’s one reason.

      The other, probably more important reason, is that the boundary condition is potentially further away than you think (although at times in the crisis there were a few bonds that actually traded through the theoretical barrier). Deflation affects the TIPS coupons – even if it doesn’t affect the ultimate principal because there is no accretion to lose, it will affect the interim principal on which coupons are based. So if you are expecting deflation, then there’s still some reason to prefer Treasuries with their fixed coupons to TIPS (but of course, your loss is quite limited while the upside is quite substantial if inflation goes the other way). For very short tenors or very low coupons, this is a small effect but it gets bigger as you go along. For 2-year TIPS, the fact of embedded accretion is a far more important point. But if there were unaccreted bonds at each maturity point, then in principle your short bonds would be bounded by zero but your longer bonds would not be. (Hint: it’s related to the size of the PV of the principal as a proportion of the whole bond value – think of the p-strip as a limiting case.) That’s probably enough for this reply. 🙂 Great question!

  4. January 7, 2015 at 7:34 pm

    Glad you finally wrote again.

    • January 7, 2015 at 9:22 pm

      Shucks, thanks! A customer sent me a note beseeching me (maybe that’s strong) to start writing more frequently again. So I will try in the new year.

  5. Joseph Chan
    January 7, 2015 at 10:21 pm

    what do you think of the collapse in oil and how does that affect inflation near and long term. i’d love to see a write up on that unless you have done so and i’ve missed it.

    Sincerely yours, Joseph Chan

    Date: Wed, 7 Jan 2015 21:14:26 +0000 To: joseph_o_chan@hotmail.com

  1. January 8, 2015 at 8:18 am

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