Inflation Protected Bonds Augur Bond Market Meltdown

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Bond market expectations are changing pretty fast. The market for Treasury Inflation Protected Securities (TIPS) no longer prices in the deflationary expectations it used to.

Bloomberg: The gap between yields on Treasuries and so-called TIPS due in 10 years, a measure of the outlook for consumer prices, closed above 2.25 percentage points four days last week, the longest stretch since August 2008. That’s the low end of the range in the five years before Lehman Brothers Holdings Inc. collapsed, and shows traders expect inflation, not deflation in coming months, said Jay Moskowitz, head of TIPS trading at CRT Capital Group LLC in Stamford, Connecticut.

The securities pay interest on a principal amount that rises or falls based on the consumer price index. Inflation- protected bonds due in 10 years yield 2.29 percentage points less than Treasuries. That gap, known as the break-even rate, has risen from 0.04 per cent in November 2008. It averaged about 2.42 percentage points in the five year’s before Lehman went bankrupt.

Given massive investor flows into bond funds this year, and their relatively blind nature (average investors looking at past bond performance, then simply ticking ‘bonds’ for their retirement allocations), expect the bond market to have a lagged response if signs of inflation, rather than deflation, pick up.

Combined with the prospect of higher interest rates, it seems bonds have only one way to go… unless of course you believe the U.S. will fall back into a deflationary recession (it must be both).

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