MBS Day Ahead: Did The Fed Back Itself Into a Corner on Inflation? Let's Find Out

In the October 29th policy statement, the Fed said "market-based measures of inflation compensation have declined somewhat" which is a reference to the trading levels in Treasury Inflation-Protected Securities (TIPS) relative to their respective benchmarks.  More simply put, "inflation compensation" = 10yr Treasury yields minus 10yr TIPS yields.  If 10yr yields are 2.32 and TIPS yields are .54, inflation compensation is 1.78.

But what is it really?

To understand inflation compensation, we first have to internalize an important concept in bond markets.  An example will help.  Imagine you buy some 10yr Treasuries.  You give the government some cash, and in exchange you'll earn a fixed rate of return.  From day one, you know exactly the amount of dollars you'll receive by the end of 10 years.  

What you DON'T KNOW is what those dollars will buy in 10 years!

The greater the rise in inflation, the lower your rate of return (prices up, yields down!).  Let's say you're going to collect $100 in interest over time, and you can currently get a cheeseburger for a dollar.  If the price goes up to $2 over 10 years, your Treasury investment is worth half as much as it was on the day you bought it.

But of course you and other investors are expecting some constant amount of inflation, and before you buy something like Treasuries you'd need to be COMPENSATED for that expected inflation.  Because of that, Treasury yields actually contain 2 components: the actual rate of return you're expecting and the amount of yield you're expecting to get gobbled up by inflation (aka "inflation compensation").

TIPS yields are immune from inflation.  They represent the actual rate of return.  That's why when we subtract that actual rate of return from regular old Treasury yields, we're left with that inflation compensation component (also known as "TIPS Breakeven").  In other words, this is the expected rate of inflation according to market forces. 

This isn't a perfect way to measure inflation expectations in markets due to the fact that TIPS are securities that rely on liquidity and other tradeflow considerations.  So there's some amount of distortion, but in general, referencing "inflation compensation" is the Fed's way of saying "here's what traders and investors are willing to agree to financially.  Here's what inflation looks like based on big boys and girls putting their money where their mouths are.  Here's what MARKETS are saying inflation will be like."

They played that card in order to differentiate it from another kind of inflation--the kind based on what consumers feel inclined to say on phone surveys.  In short, the Fed is saying that markets are too concerned about inflation and consumer attitudes suggest things will soon be improving.  The tacit conclusion is something like this: "therefore, removing the last of these asset purchases and evolving the dialogue to focus on rate-hike timing is justified.  SEE?!  See how justified it is?  This stuff that we're doing that might not necessarily make sense?!"

It's a pretty clever idea, and in fact, a pretty legitimate conclusion.  After all, if consumers are expecting to pay higher prices, then markets really would be overly concerned and the Fed really would be super justified in sticking to their taper timeline.  But since the Fed meeting, we saw inflation expectations precipitously tank to the lowest levels since March 2009!  Backfire!!!

All this to say that today's Fed Minutes could confirm this little scheme.  If today's Minutes suggest the Fed is leaning on this inflation dichotomy to justify a removal of accommodation, markets could easily read that in one of two ways--both of which would be helpful for us.  Either the Fed is no longer as justified in removing accommodation or the Fed doesn't really have a great way to justify it and was ascribing to the "fake it till you make it" philosophy.    Bond markets would likely enjoy either conclusion because it leaves low policy rates as one of the only remaining arrows (because firing back up asset purchases is too big of a risk from a credibility standpoint). 

In short, if the Fed backed itself into a corner, it's our corner.

On a final note, speaking of "fake it till you make it," here's the visual representation of TIPS breakevens (inflation compensation), which the Fed characterizes as having "declined somewhat."  Call me crazy (and I know the Fed has a longer term point of view), but this looks like a pretty serious shift--much more than "declined somewhat."  Maybe the Fed meant to say "markets think inflation is gonna tank and we're counting on optimistic consumers prove them wrong."