Market Based Pricing Suggests We May Have Seen Peak Inflation

The breakeven spread is the implied rate of inflation between nominal bonds and inflation protection bonds (TIPs. Real Return). The breakeven rate is a market-based price of inflation expectations. We can see by looking at the 2-to-5-year part of the curve that expectations have not gotten much worse since the major Russian-Ukraine war started on Feb 24th, 2022. Long-term inflation expectations remain well contained.

US 2-Year Breakeven

It’s clear the supply chain and labour issues along with massive cash payments to households and business since covid has led to higher inflation expectations over the near to medium term (next few years). But looking closer at the post Russia-Ukraine invasion that clearly spiked oil prices, we see that peak inflation expectations likely has already passed. The spike in expectations post CPI report is now back to pre-CPI levels.

US 2-Year Breakeven Rate Now lower than on Feb 24th

Another market-based lens on measuring inflation expectations is an inflation swap contract. An inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In a zero-coupon inflation swap, only one payment is done at maturity where one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index. The shape of the two curves are basically the same, but there are some small differences. The main differences are the zero coupon and the pure swap of realized inflation. The pure inflation swap is not yet lower than seen on Feb 24th.

US 2-Year Zero Coupon Inflation Swap

Long-term inflation is best measured by the FOMCs favourite indicator. The 5-year inflation swap rate priced 5 years from today. While this measure of longer-term inflation is elevated relative to the past 10 years, it’s well below that of the previous decade. With structural changes including massive debt and poor growth demographics, deflationary forces are still part of longer-term expectations.

US 5-Year, 5-Year Inflation Swap

We are often asked about how to play this from an investment standpoint and our answer has been cautious. Inflation expectations are a difficult measurement. It’s not as simple as buying inflation protection bonds. We found an ETF that does a good job in isolating just the inflation aspect that most are concerned about that tries to neutralize the interest rate risk linked to it.

The RINF-ProShares Inflation Expectations ETF offers a portfolio of 30-year Treasury Inflation-Protected Securities (TIPS) bonds and seeks to mitigate the risk of rising rates through a built-in interest rate hedge using U.S. Treasury futures. It is designed for investors concerned about inflation and rising rates. The chart we prepared shows the total return of the iShares TIP Bond ETF (TIP), the iShares 20-year plus bond ETF (TLT) and the RINF ETF. It’s clear the ETF does a good job at isolating the rising inflation expectations.

The caveat here is that if market-based inflation expectations have peaked, the RINF ETF will likely start to fall. But if you believe inflation expectations will continue to rise, this ETF should provide some upside. I’m in the peak inflation camp here and this ETF will only help if inflation expectations continue to rise. I do think inflation will be elevated for the next few years. If a recession is coming, the TLT is the best way to play it.

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