Wednesday, February 8, 2012

Inflation expectation rises above 2%

The US two-year breakeven rate, which is the implied forward spread between treasuries and TIPS, has quietly risen above 2%. This is a measure often used as a market-implied inflation expectation indicator. Normally such an increase would not be a big deal, except that the Fed is now targeting 2% inflation rate. The market however is pricing inflation expectations above that level within the next two years.

US Breakeven 2 Year (Bloomberg)

The Fed Funds Futures have responded accordingly, implying overnight rates of around 50bp (two rate increases) at the 2.5-year point (30 months out). The market has basically discounted the Fed's announcement that rates will stay at zero for a longer period.  The rate implied by the Fed Funds futures 2.5 years out has risen above the pre-Fed announcement levels.

Fed Funds Futures implied rate 30 months out (Bloomberg)

This should make Bernanke happy because deflationary pressures have largely been alleviated (for now) while significant additional quantitative easing is now more difficult to justify.
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