Thoughts on US inflation trends - March 2017

Seven years of unconventional monetary policies finally gave way to higher inflation expectations.

CPI is printing above the 2% FED target and 10yr break-even crawling back above the 200 mark.

Nominal rates are marching higher mostly as a re-pricing of term premiums. Real rates if higher in 2016 remain pretty contained with 5yr rates still in negative territories.

Let's look at various value measures and some of the new dynamics affecting break-evens.

TIPS Liquidity Premium = Bloomberg inflation forecast – 10y BE

Using Professional forcasters survey instead of BBG forecast

 Measures of 5y5y forward BE inflation

5yr Break-evens vs CLA, retail gas (a smoother version of CLA) and Commodity index

Some de-correlation becoming apparent, other reflationary factors weighting more on BE besides commodities and energy (Fiscal policy, wage growth…)

Interestingly 5/30 nominal and real curves are diverging as 5yr real yield staying anchored in negative territory…suggesting 5/30 nominal too flat or 5/10 real too steep

2-5-10 nominal and real butterfly as a value indicator

5yr real yield repricing hard (white line) since early march compared to nominal yields. Are 5y nominal treasuries too cheap on the term structure, they are certainly good value on a cross sectional vs Europe, CAD or cross assets MBS, credit…

At this point 5y real yields look expensive both on term structure or vs commodities complex as BE shows.

To be fair, longer time frame show both markets fair, what’s interesting is that 5y real yield are more volatile due probably to real money positioning and liquidity constraints but a good mean reverting vehicle.

Term premiums have stabilized helping treasuries take a breather but might just build a flag pattern before resuming higher

Two measures of risk premiums

PCE vs CPI spread, stable for the last 2yrs but high vs 5y average

For a quick and dirty understanding of the differences between the two baskets http://www.businessinsider.com/pce-vs-cpi-weight-comparisons-2014-6

CPI fixed weights while PCE incorporates revisions

Shelter is a big component of CPI

Health care and financial services better represented in PCE

Recently Shelter measures have been more subdued but core goods elevated, higher oil prices may be having an impact. We are also entering a period when seasonality impact carry and support Tips prices.

The graph below shows CPI seasonality and how core prices tend to be higher from March to September. That said, Core CPI despite being adjusted for seasonality tend to be higher in the first half of the year vs second half of the year. This explains idiosyncratic relative expensiveness of Tips in one period vs the other, as carry becomes a differentiating factor. Might explains 5y richness on the curve that started early march.

Overall long term model shows 10 Real Yield too low by 25bps vs fair value at the end of February

Model is based on Real short rate (SR), 1y Momentum in real SR, changes in core CPI, Changes in GDP