The Treasury market’s inflation forecast has recently risen to the levels that prevailed before Lehman Brothers collapsed in September 2008, which triggered a financial crisis and fears of a deflationary spiral. Using the yield spread between the nominal and inflation-indexed 10-year Treasuries, the market’s outlook has come full circle since the dark days of late-2008.

As of yesterday, 10-year Treasuries expect inflation on the order of roughly 2.5% in the years ahead. The question is whether that outlook will remain stable?

This is the second time since the financial crisis that the market priced Treasuries for 2.5% inflation. A year ago, something similar was built into prices, only to give way as heightened fears of recession risk, triggered by troubles in Europe, changed the crowd’s sentiment.
There’s no shortage of worries these days, of course, but the market’s outlook on inflation remains relatively stable… so far. In fact, investors should watch this market gauge as an early warning sign of trouble. If the economy is headed for a new rough patch, clues of what’s coming may show up in the market’s inflation prediction.
In May 2010, the market’s forecast turned down relatively quickly in advance of the summer economic troubles that eventually convinced the Fed to launch QE2. That decline was accompanied by a fall in stock prices. The S&P 500 peaked in late-April 2010, dropping sharply through the spring and summer.
If there are new problems brewing in the economy, it wouldn’t be surprising to see the Treasury market’s inflation forecast wilt. For the moment, there’s no sign that the market expects inflation to fall. Meanwhile, U.S. equities have rebounded strongly in the latter half of March after a correction in the first half of the month.
Friday brings the first data points for March’s economic profile, with updates on the ISM Manufacturing Index and nonfarm payrolls. The market will be carefully analzying these reports for confirmation, or rejection, that the economy is weathering the Ides of March.