- Inflation break-evens continue to price in a low long-term inflation outlook the likes of which we have not seen since the Great Depression despite surging money supply growth.
- We would not be surprised to see inflation head into the high-single digits towards the second half of the decade as investors balk at the prospect of indefinite deficits.
- Break-evens have largely shrugged off the strong recovery in inflation-sensitive assets, in particular high-yield credit spreads and yen crosses, suggesting there is room to play catch-up.
U.S. break-even inflation expectations remain unfeasibly low despite the strong recovery in inflation assets globally. Amid a continued rally in gold prices, a recovery in the commodity complex, particularly oil, and a broad-based weakening of the dollar, 10-year break-evens continue to price in a very low long-term inflation outlook the likes of which we have not been seen since the Great Depression.
When it comes to financial markets, particularly these days with oil having recently traded below zero and U.S. tech stocks testing all-time highs despite an unprecedented economic collapse, we cannot rule anything out. However, for inflation to average so far below its long-term trend in the face of massive government debt issuance and Fed monetization seems very difficult to imagine. It is also worth noting that the current riots are intensely inflationary as productive assets are being destroyed and fiscal costs are rising further.
Asymmetric Upside Risks
We entered into a long position on the ProShares Inflation Expectations ETF (RINF) on April 22 which is designed to track 30-year break-even inflation expectations – a market-based measure of inflation based on the difference between regular and inflation-linked Treasuries. The index is up almost 8% since we entered and we continue to see it as a highly attractive risk-reward play given the ongoing rise in debt issuance and money supply. A move in 30-year break-evens back to just 2.0% would result in roughly 15% gains from here.
The 10-year break-even is perhaps even more underpriced than the 30-year, currently trading at just 1.2%. This figure seems incredibly low given the long-term trend of inflation averaging considerably higher. In fact, on a 10-year average basis, the last time consumer price inflation averaged as low as 1.2% was back in 1941 – a 10-year period which included the deflationary depths of the Great Depression during which time the money supply reportedly fell by a third. The contrast between now and then could not be starker. The possibility of a decline in the money supply over the coming years is negligible given the ability and willingness of the Treasury and Fed to issue and monetize debt at will.
High Single-Digit Inflation Likely Within Next Decade
As near-term deflationary pressures abate and fundamental inflation pressure begin to show through into the consumer price basket, we expect to see 10-year break-even inflation expectations to recover to the 1.5-2.5% range where they have spent the bulk of the past 20 years. Over a multi-year period, we would not be surprised to see them head into the high-single digits towards the second half of the decade as U.S. and foreign dollar holders balk at the prospect of endless fiscal deficits.
Other Inflation Assets Are Leading The Way Higher
Not only are break-evens at odds with the long-term macroeconomic outlook, they are also at odds with the price action seen across inflation-sensitive assets. As we argued previously, the fact that break-evens tend to move in close correlation with oil prices reflects the impact of declining oil prices on U.S. and global credit markets, which increases demand for dollars and puts downside pressure on inflation expectations. With this in mind, the rebound in high yield and energy sector credit spreads suggest that the near-term deflationary pressures driving down break-evens have largely abated. Based on the strong historical correlation between credit spreads and break-evens, 10-year inflation expectations should be trading closer to 2%.
Source: Bloomberg, Barclays
The weakness in the dollar is also pointing towards a recovery in inflation, with the greenback recently giving way to the euro and sterling following a trend of weakness against emerging and commodity currencies. The yen cross in particular is looking strong, with AUDJPY recovering the entirety of the March declines and breaking above trendline resistance today.