On Thursday, the government will release its December report for inflation. But it looks like it’ll be a non-event because the crowd believes that consumer prices are no longer a threat.
One measure of the market’s comfort that prices are contained can be seen in inflation-indexed Treasuries, otherwise known as TIPS. The spread between the yields on standard 10-year and 10-year TIPS was a mere 2.28%, as of last Friday’s close. That’s near the lowest levels of recent years. The implication: the market’s not worried about future inflation and has become less worried of late.
Contrarians may want to take a closer look. The fact that the yield spread between nominal and inflation-indexed 10-year Treasuries has fallen to 2.28% also means that the break-even hurdle for TIPS is lower. If top-line inflation runs above 2.28% going forward, a 10-year TIPS will probably deliver a higher overall total return compared with a nominal Treasury of the same maturity.
Of course, Mr. Market thinks otherwise, which is why the spread (or breakeven point) is so low these days. Indeed, top-line inflation rose by just 2.0% for the past year through last November, or 28 basis points below the spread. Expectations are low that inflation will exceed that level any time soon. Then again, it was only in July that consumer prices were advancing by more than 4% a year. But that was so yesterday.
Consider that the iShares Lehman TIPS ETF has lost one-half a percent over the past 12 months through January 12, according to Morningstar.com. That compares with a 2.4% gain for the iShares Lehman 7-10 Year Treasury ETF. In short, betting that inflation would rise has been a losing proposition.
The question, as always, is whether yesterday’s winning bet will continue to win? It’s a close call at this point, judging by the outlook for December’s inflation report. The consensus prediction for Thursday’s CPI report calls for a 0.4% rise in top-line inflation for December, according to Briefing.com. If accurate, that would be the highest monthly pace of inflation since July and a sharp jump up from November’s zero percent change. Even so, will a 0.4% rise in inflation be enough to convince Mr. Market that TIPS are again worthy of ownership at the expense of nominal Treasuries? Tune in Thursday morning for the answer.