- The collapse in oil prices has put renewed downside pressure on breakeven inflation expectations, which are now completely out of line with the fundamental inflation outlook facing the U.S. economy.
- The ProShares Inflation Expectations ETF tracks the performance of the FTSE 30-Year TIPS Index, where we expect to see a strong recovery once near-term credit stresses abate.
- Breakevens are being undermined in the near time by the collapse in energy prices, but it is far from clear why this should be the case.
- Even a return to the relatively low trailing CPI rate of 1.5% would imply a 20% price gain in addition to the income payments which track CPI itself.
The collapse in oil prices has put renewed downside pressure on breakeven inflation expectations, which are now priced at levels which we think are completely out of line with the fundamental inflation outlook facing the U.S. economy. The ProShares Inflation Expectations ETF (RINF) tracks the performance of the FTSE 30-Year TIPS Index, where we expect to see a strong recovery once near-term credit stresses abate.
The 30-year breakeven inflation rate (inflation expectations calculated based on the spread between regular and inflation-linked Treasury bonds) is now at just 1.28%. This is close to the lowest it has ever been, with the exceptions of the 1.0% level seen during the height of the recent credit crunch and the 0.7% lows that followed the Lehman bankruptcy in 2008. The RINF is trading down roughly 50% from its 2012 peak as 30-year breakevens have halved. Even a return to the relatively low trailing CPI rate of 1.5% would imply a 20% price gain in addition to the income payments which track CPI itself, and should outweigh the impact of the ETF’s expense ratio.
ProShares Inflation Expectations ETF vs. 30-Year Breakeven
Longer term, we expect the Urban Consumer inflation rate, which the inflation expectations are based on, to average closer to its 50-year average of 4.0% and see the tail risks as heavily skewed to the upside. The high level of domestic and external government debt should ensure that inflation trends dramatically higher than the current rate implied by 30-year breakevens. It is worth noting that we have never seen a 10-year period where CPI has averaged less than the current breakeven level.
Oil Price Collapse Is A Temporary Factor
Breakevens are being undermined in the near term by the collapse in energy prices, but it is far from clear why this should be the case given that low oil prices will have no bearing on the average inflation rate over the next few decades. A 2019 study by the St Louis Fed effectively drew the same conclusion analyzing data from 2003 to 2015.
Our view is that oil prices themselves are not what are actually driving long-term inflation expectations. Rather, the close correlation between oil prices and breakevens reflects the fact that declining oil prices cause stress in the U.S. and global credit markets, which increases demand for dollars and puts downside pressure on inflation expectations. As the chart below shows, there is a much stronger correlation between breakevens and credit spreads (both the Barclays U.S. High Yield Spread and the High Yield Energy Spread) than there is between oil prices and credit spreads.
Source: Bloomberg, Barclays
Long-Term Outlook Highly Inflationary
The close link between credit spreads and breakevens explains why in the near term negative economic growth shocks tend to result in downside pressure on inflation expectations. This means that should we see the oil price collapse trigger another bout of U.S. and global credit stress, RINF could see further downside. However, from a longer-term perspective, weak economic growth is likely to be an inflationary force rather than a disinflationary one, for two reasons.
U.S. Real GDP Growth vs. Consumer Price Inflation
Firstly, as explained in “The Coming Stagflation And The Case For Silver“, the U.S. weak growth outlook should act as a direct inflationary force over the coming years. As the chart above shows, there has tended to be a negative correlation between real GDP growth and inflation in the U.S. over the long term, with high inflation rates occurring amid economic contractions. Secondly, the latest deflationary shock has triggered an all-out government and central bank inflationary response, which looks set to dwarf the response seen during the height of the Global Financial Crisis and should overwhelm the near-term deflationary forces.