Yes, Mr. Bernanke, TIPS Break-evens Say Inflation Expectations Are Rising

We Recently Received The Following Question In Regards To Our Comments On Inflation Break-evens

I am really confused by your assertions about inflation expectations.  Are you using the 5-year inflation break-even rate or the 5yr/5yr forward inflation break-even rate?

I show 5-year nominal yields up about 135 bps since November 3 and that 5-year inflation break-evens have gone up 45 bps.  So the biggest share has been the rise in real yields.

What is your beef about this being misreported?

Last week we challenged Chairman Bernanke about his comments on the TIPS markets when he said:

Bernanke: The inflation break-evens have risen since we began the QE2 program in August, but they have moved from very low levels to about normal levels. The bulk of the increase in interest rates has been in the real side of the interest rate, which means that, like the stock market, the bond market is expecting greater future growth and is more optimistic about the U.S. economy. And I think that’s a good thing, obviously, and I think our policies have contributed to that.

While Bernanke asserted rates were rising on the back of higher real growth expectations, we believe the TIPS market is showing inflation to be behind the rise in rates.

Since November 3rd Half The Rise In Rates Is Due To Higher Inflation Expectations

Bernanke was referring to the 5-year inflation break-even rate which is often calculated by subtracting the yield of the current 5-year note, now the 2.00% of January 2016, from the current 5-year TIPS (0.5% of April 2015).  Using these reference points, we constructed the table below.

Measuring Change In Yields, Real Yields And Inflation Break-even Rates
Using The Current 5-Year Treasury Note
Since the Fed FOMC Meeting On November 3, 2010

Using these measures, 67 of the 123 bps rise (55%) in the current 5-year note can be explained by rising inflation expectations.

However, this is not the only way to measure inflation break-evens.  Bond traders use a better duration-matched Treasury note, the 2.50% of April 2015.  Bloomberg uses this Treasury note in constructing its inflation break-even series (USGGBE05 <Index>). Redoing the table using the 2.5% of April 2015 Treasury note we get:

Measuring Change In Yields, Real Yields And Inflation Break-even Rates
Using The 2.50% of April 2015 Treasury Note
Since the Fed FOMC Meeting On November 3, 2010

Using this measure, 46% of the rise in rates can be explained by rising inflation expectations.

Rounding off the two measures above suggests about half the rise in rates since November 3, 2010 can be explained by rising inflation expectations.  Bernanke said, “The bulk of the increase in interest rates has been in the real side of the interest rate.” Whether “bulk” means “half” we’ll leave for etymologists to determine.

More importantly, our questioner made a very common mistake when calculating break-evens.  They compare the change in 5-year TIPS inflation break-even rates using the 2.50% of April 2015 Treasury yield (literally using the Bloomberg measure) to the change in the current 5-year Treasury yield.  Since this part of the yield curve is very steep, mixing these apples and oranges gives a wildly distorted view and the impression that the “bulk” of the rise in interest rates has indeed come from a rise in real yields.  This is simply an incorrect way of measuring it.

“Since We Began The QE2 Program In August”

While Bernanke’s assertions are tenuous when viewed from a November 3 start date, note that in the passage above he said, “since we began the QE2 program in August … [t]he bulk of the increase in interest rates has been in the real side“.

While many want to use November 3 as the official start of QE2, note that the Federal Reserve first began buying bonds in August to hold the size of their balance sheet steady.  It was on November 3 that the FOMC agreed to expand the their balance sheet via QE2.

Bernanke used August as his starting point of QE2, so we will also use it.

On August 27, 2010 Bernanke gave a speech in Jackson Hole, Wyoming which many consider to be the unofficial announcement of QE2.  We will use this speech’s date as our August reference point (although almost any other date in August would give similar results).

The table below uses the current 5-year (January 2016 2.00% coupon) as its benchmark and uses August 27, 2010 as its starting point:

Measuring Change In Yields, Real Yields And Inflation Breakeven Rates
Using The Current 5-Year Treasury Note
Since Bernanke’s Jackson Hole Speech On August 27, 2010

Using the 2.5% April 2015 Treasury note as a benchmark, we get much the same result:

Measuring Change In Yields, Real Yields And Inflation Breakeven Rates
Using The 2.50% of April 2015 Treasury Note
Since Bernanke’s Jackson Hole Speech On August 27, 2010

Since August, both of these tables show the 5-year inflation break-even rate is up more than nominal yields.  This means all of the rise in nominal interest rates since last summer can be attributed to higher inflation expectations.   This is exactly the opposite of Bernanke’s contention that “the bulk of the increase in interest rates has been in the real side“.  In fact, none of the rise in yields since August has come from higher real rates.

For those that are more visual, the next chart shows the current 5-year yield (top panel), 5-year real yields (middle panel) and the inflation break-even rates (lower panel).  This graph uses the current 5-year (Jan 2016 2.00% coupon) as its benchmark.

<Click on chart for larger image>

Conclusion

Why do we obsess over these statements?  They drive to what Bernanke is doing.  He wants to “print money” (QE2) and does not want inflation worries to stop him, even if they actually exist.

Bernanke: Let me say first that there be no doubt that we are unwaveringly committed to maintaining price stability. That is a very, very strong goal and objective. We will do so. In terms of what we are looking at, first of all, overall inflation, including food and energy, is still very low, about 1 percent. But looking forward, you asked about credibility in the yield curve. If you look for example at inflation break-evens, which are a measure in the inflation index bond market of what the markets think inflation is going to be, the five-year break-even is about 2 percent, 2.1 percent last I’ve looked. So there is not really any indication in our financial markets that in the United States there’s an expectation of inflation. That being said, we will look very carefully not only at output gaps and those things that you’ve mentioned, but also at commodity prices, at interest rates and all the other indicators that will help us assess when inflation is becoming a problem.

Bernanke has an unwavering commitment to preventing inflation from flaring up.  Break-even rates are one of his favorite measures of inflation expectations.  Yet, when interest rates rise in conjunction with higher TIPS inflation break-even rates, he misconstrues the data and comes to factually incorrect conclusions.  In our eyes this leaves him with little credibility on this front.

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