May long-term inflation levels be higher? This indicator for predicting inflation is not...

Strategists say that the indicator commonly used by the market to predict inflation trends does not fully reflect price trends because it misses an important factor, which may lead to an underestimation of future inflation

Macro Strategist Simon White（Simon White）It is stated that the inflation breakeven, i.e. the difference between nominal and actual returns, does not fully measure future price growth, and long-term inflation levels may be higher than currently implied levels.

He said that in this cycle, the biggest focus of the market is on inflation trends. By solving this problem, it's easy to answer many other investment questions. The inflation breakeven implies that inflation will soon return to a low and stable level.

However, from experience, this indicator cannot predict future inflation very well. In fact, a deeper study of how this indicator is constructed and traded reveals why it should not be considered an accurate predictive indicator. White believes that long-term inflation may be higher than expected breakeven.

Inflation Breakeven is an inflation protected bond（TIPS）The interest rate required to break even between long positions and short positions in long-term US treasury bond bonds. Functionally speaking, it is different from theforeign exchangeThere is no difference in the implied future foreign exchange spot exchange rate for forwards. And no one in the market would claim that foreign exchange forward rates are actual and reliable predictions of the possible direction of spot exchange rates.

But people believe that the inflation breakeven has been magically endowed with the ability to predict the future of inflation to some extent. However, this is unfounded as the balance is often higher or lower than actualCPI。

The following chart shows10The inflation breakeven of the year is consistent with its forecast10Annualization of yearsCPIFor comparison, the blue color at the bottom shows the degree of deviation between the two. In recent years, this gap has narrowed somewhat, but this is only relative because in20century70Age and80In the era, this gap was very large.


Those decades, just like now, were the main turning points for inflation, and the inflation breakeven at that time was the most unpredictable for actual inflation.

To understand why, it is necessary to introduce oil. It has a very high correlation with inflation breakeven, far exceeding expectations based solely on its direct impact on inflation.


This strong relationship stems from the interdependence of two markets. Oil is often used as a hedging tool by commodity traders. As oil prices rise, inflation traders will push upTIPSLeading to a decrease in its actual yield, thereby pushing Qualcomm(111.2763, -0.40, -0.36%)Break even with inflation.

However, although the inflation breakeven has increased, the main driving factor is not the prior changes in inflation expectations. From the perspective of the model, the inflation breakeven generally assumes that inflation compensation only includes expected inflation and inflation risk premiums, but does not includeTIPSThe liquidity premium, but as we can see from the figure below, the only biggest explanatory factor when oil prices and yields change isTIPSLiquidity premium (dark blue line), rather than expected inflation or inflation risk premium.

(Note that in the following figureTIPSThe actual correlation between liquidity premium and inflation compensation is negative, that is, when liquidity premium decreases, inflation compensation increases


This is important because it indicates that even if there is no fundamental change in inflation expectations, the inflation breakeven may still improve. But when the rise in oil prices triggers an increase in inflation breakeven, most of the differences in the changes can be explained by a liquidity premium, as the liquidity premium will affect theTIPSThe demand for goods increases and decreases.

　　TIPSThe role of liquidity premium reveals another relationship, namely the almost abnormally high correlation between inflation breakeven and high-yield credit spreads. As shown in the figure below, the rise in inflation breakeven and the narrowing or easing of credit spreads are almost synchronous.


And the changes in credit spreads have a significant impact onTIPSThe liquidity premium is the most sensitive. White stated that the correlation between inflation breakeven and investment grade credit spreads is not high, indicating that when the actual yield decreases due to inflation, junk bonds with higher beta coefficients will benefit more, and junk bonds will also benefitTIPSThe risk premium impact that may occur when the liquidity premium decreases.

White stated that this does not mean that the inflation breakeven has no predictive effect on inflation, but an understanding of its potential drivers suggests that they are usually not primarily driven by changes in inflation expectations.

Therefore, he said that if you want to avoid being hit by another acceleration of inflation by predicting it, then the inflation breakeven may not be a good indicator. Because this indicator will only rise when prices truly rise, it will be too late because the prices of stocks and bonds may already reflect the new reality of high inflation.