Mr. Market has been wearing optimism on his sleeve when it comes to estimating the future path of inflation by way of the spread between nominal and inflation-indexed Treasuries with 10-year maturities. But the optimism that has been fashionable this season past may fall out of favor this summer as inflation fears heat up.
As of last week’s close, the nominal yield on a 10-year Treasury was 5.06%, according to the databank maintained by the U.S. Treasury. The 10-year inflation-indexed Treasury (or 10-year TIPS, as everyone likes to call them) ended the week at 2.44%. The spread between the two was 2.62% (5.06 less 2.44). In other words, Mr. Market’s forecast of inflation is 2.62%, as the chart below illustrates.

How high is 2.62% as an inflation forecast? Arguably, not high enough, even though it represents the upper range based on the last three years, and up about 30 basis points from 2005’s close. But on one level, at least, 2.62% as an inflation expectation appears more than a little dovish. We come to the conclusion by pointing out that 2.62% is considerably below the 3.5% current annual pace of increase in consumer prices.

Granted, there are several ways the imbalance can be corrected, which, we’re confident, is coming. The means for the correction, as well as its timing, are the great mysteries, although we have our suspicions on those fronts as well. In any case, a wider spread between the nominal and TIPS yields might be forged with more than a little selling in the nominal Treasury.
In order for the nominal/TIPS spread to match the current annual rate of CPI increase, the 10-year Treasury’s 5.06% would need to jump to 5.94% (assuming last Friday’s TIPS yield remained unchanged). The drawback to such an alignment would entail the bond market getting crushed, to use the technical term for heavy selling.
An alternative scenario would no doubt be preferable to the fixed-income set, at least temporarily, although it’s not entirely clear such an outcome is imminent. Nonetheless, if TIPS buying surged, and in the process decreasing the associated yield to 1.56%, the expected inflation outlook drawn from the nominal/TIPS spread would match the latest annualized pace of CPI’s increase (assuming the nominal yield remained unchanged).
Of course, this is the moment in our essay to point out that any robust buying of that degree in the TIPS would eventually (if not immediately) gain attention in the capital markets far and wide, thereby sending an inflationary warning whose repercussions would likely echo bearishly in the pricing of other yield-sensitive instruments.
Of course, the optimists are quick to point out that the third way for the inflation outlook born of the nominal/TIPS spread to come into line with CPI is for the latter to fall. By that reckoning, the current 3.5% CPI rate would be required to descend to the 2.6% range, give or take. For the sake of historical perspective, the last time CPI’s annual pace paid a visit to that neighborhood was June 2005, when consumer prices advanced 2.5% over the year-earlier month.
Or, perhaps some mix of all three will arrive.
So many variables, so many possibilities, although in the end it all boils down to the simple question: Are you bullish or bearish on bonds?