Late last month, we discussed the fact that the strange case of parity had arrived for the yields of the 10-year Treasury and its inflation-indexed counterpart. The conventional 10-year yielded a mere 13 basis points over the 10-year TIPS as of December 26. That was highly unusual, as we pointed out, in part because a conventional Treasury should normally pay a substantial premium over an inflation-indexed bond of the same maturity as compensation for bearing inflation risk.
Of course, the “normal” scenario applies when inflation is generally the path of least resistance. Over the grand course of history, that’s far and away the standard scenario, as fiat currencies have a perfect record of fomenting inflation. But in the shorter term alternative afflictions are possible in the realm of monetary economics, as the last few months remind.
Getting back to our story, last month we observed that when the yields of standard and inflation-indexed Treasuries were virtually identical, buying the inflation-indexed bond was a no-brainer. Why? Because there’s no reason to turn down a Treasury security that offers both inflation insurance at essentially no extra price. Yes, that apparent deal may not look so good if deflation prevails over the life of the bond, which in this case is the next 10 years. But few are expecting such a long-running case of deflation over the next decade, at least not yet–thus the perceived opportunity.
The fact that the two yields were more or less comparable to begin with is a reflection of the strange state of finance these days. Although it represented a rare opportunity for bond investors, it’s not an encouraging sign generally. As such, one might reason that the widening spread between the two yields in recent weeks, as the chart below shows, is something to cheer. Even so, we shouldn’t break out the champagne just yet.
The yield spread is still quite low and abnormally low. As of last Friday’s close, the spread had widened to 55 basis points, up from just 13 basis points when we wrote about this last month, although that’s still a fraction of the 225-basis point average spread since 2003.
The widening spread this month is due equally to market changes in conventional and inflation-indexed Treasuries, albeit for different reasons. Since late last month (Dec. 26), the standard 10-year Treasury Note’s yield has climbed slightly by 20 basis points to 2.36%, as of last Friday. Over the same stretch, the 10-year TIPS’ yield has fallen by 22 basis points to 1.81%.
What does it all mean? On the one hand, the consensus outlook for inflation has risen, if only slightly and off a bottom of roughly zero. As such, it’s too soon to say if the change is just trading-related noise. Nonetheless, the market’s now expecting that inflation will average roughly one-half of a percent for the next 10 years. Late last month, the market was in effect forecasting no inflation to speak of for the decade ahead.
In the upside-down world we currently live in, that constitutes progress, spare and vulnerable though it is. A little bit of inflation, in other words, is just what we’re looking for to stave off deflation. Keeping a lid on it in the longer run will prove to be a tough challenge, but for the moment higher inflation is something to celebrate when deflation is a real and present danger.
Alas, it’s still too early to say if we’re on the cusp of witnessing higher inflation, even though the Federal Reserve is working hard to deliver just that outcome. We’re going to have to several months before more concrete signs of the Fed’s deflation battle emerge. But for the moment, a thin reed of hope is tenuously peaking through the January deflationary ice. Let’s hope the spring thaw comes early this year.