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Below is an excerpt from a commentary posted at www.speculative-investor.com
on 28th June 2015. Excerpts from our newsletters and other
comments on the markets can be read at our blog: http://tsi-blog.com/
Inflation expectations bottomed in January of this year, or, to put it
another way, deflation expectations peaked in January of this year. The
question is: did the January reversal mark a 1-2 quarter shift or a much
longer-term shift? We think it will prove to be the latter, although we
hasten to point out that we are not anticipating a dramatic increase in
inflation fear within the next year -- just the dawning of a general
perception that more "inflation" lies ahead.
Evidence that US inflation expectations bottomed in January of this year is
contained in the performance of the US yield curve, as indicated on the
following chart by the 10yr-2yr yield spread. The chart shows that the
10-year yield started rising relative to the 2-year yield near the end of
January.
There are two possible causes of a significant rise in the 10yr-2yr yield
spread. The first is increasing inflation expectations, in which case the
rising yield spread will be driven by increasing long-term interest rates or
by long-term interest rates holding up relatively well while the central bank
forces short-term rates downward. This happens because long-term interest
rates are influenced by inflation expectations to a much greater extent than
short-term interest rates. The second is the unwinding of carry trades and a
general shift away from risk, in which case the rising yield spread will be
driven by decreasing short-term interest rates.
As an aside, a rising yield-spread (steepening yield curve) is bullish for
gold regardless of whether it is driven by rising long-term interest rates
(increasing inflation expectations) or falling short-term interest rates (a
general shift towards safety). However, its bullish influence can be offset
by other fundamental drivers, as was the case in 2013 and over the past few
months.
We know that the rise in the US 10yr-2yr yield spread from its January-2015
bottom was caused by increasing inflation expectations because it was driven
by rising long-term interest rates.
The message of the US yield curve is echoed by the "Expected CPI"
(the difference between the yield on a standard 10-year T-Note and the yield
on a 10-year TIPS), which also indicates that inflation expectations have
risen markedly over the past 5 months. As evidenced by the following chart,
the rate of "price inflation" that the market expects the US
government to report over the years ahead began to trend upward in January
after falling sharply over the preceding 6 months.
 
Although it is far from a foregone conclusion, the January-2015 reversal in
the expected rate of "price inflation" probably marked the start of
a trend that will remain in force for more than 12 months. This is because
the two main drivers of the preceding decline in inflation expectations
appear to have been eliminated.
The first of these drivers was the (irrational) fear that the ECB and
Europe's banks would be unable to create enough new money and credit to
prevent the euro-zone from experiencing sustained "price
deflation". The sharp rise over the past several months in the
euro-zone's monetary inflation rate to near an 8-year high (see chart below)
has rendered this fear obsolete. The second of these drivers was the view
that the oil market's downward trend would continue well beyond the first
quarter of this year, with the price eventually falling to the $20s or even
lower. While this view has not yet been completely disproved, it is very much
a long-shot due to the oil market having traced out a pattern that over the
past 30 years has invariably marked a bottom of at least intermediate-term
significance.
It's certainly possible that the nascent upward trend in inflation
expectations will be brought to a premature end by a steep decline in the
stock market, but this is not the most likely outcome. The reason is that
even if an equity bear market were to begin this year, a price decline of
sufficient magnitude to create a deflation scare probably wouldn't happen
until next year. For example, the previous equity bear market got underway
during the second half of 2007, but a deflation scare didn't materialise
until the third quarter of 2008.
In summary, inflation expectations have turned the corner and the new trend
will be sustained through the remainder of this year and well into next year.
That's our current view, which is, of course, subject to change if
conflicting facts present themselves.
Regular financial market forecasts and analyses are provided at our
web site:
http://www.speculative-investor.com/new/index.html
Also, samples of our work (excerpts from our regular commentaries) and
additional thoughts on
the financial markets (and other stuff) are provided at our blog:
http://tsi-blog.com/
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