Much Ado About Nothing

Markets are waiting with bated breath for the Federal Reserve’s decision later today on a possible expansion of its quantitative easing programme. But what if it all turns out to be irrelevant?

For all the fuss made about QE over the last two months, inflation expectations are broadly (and surprisingly) unchanged since the beginning of the year.

Barclays Capital’s latest Linker Index Monthly reveals that breakeven inflation rates (the inflation rates derived from a comparison of yields on inflation-protected Treasury bonds – TIPS – and those on conventional, fixed-rate government bonds) are pretty much the same as they were at the beginning of 2010, at least for longer-dated bonds (10-30 year breakeven inflation rates are in the region of 2-2.5%).

In other words, that’s the market’s current expectation of what inflation will average over the next few decades. Judging by some of the recent noise being made about the dangers of a hyperinflationary outcome of current Fed policy, however, you’d be forgiven for expecting to see those same breakeven rates in the high single or even double digits.

And at the shorter, five-year maturity, the breakeven rate has actually fallen this year, from 2% at the end of 2009 to approaching 1% now.

In the UK, a very similar picture is evident. Breakeven rates have fallen steadily and modestly throughout the year (despite all the reflationary talk of the last couple of months).

In other words, there’s no evidence that bond investors are seriously concerned about the re-emergence of inflation in the US or the UK. And the little inflation that was priced into the system a year ago is – generally speaking – even less now. Isn’t that worth repeating, slowly?

What has been happening, of course, is that real yields (which drive inflation-linked bond prices) have been falling across the board. In the US market, real yields are negative up until six years’ maturity, while in the UK all index-linked gilts under eight years to maturity offer you a negative real yield. Low real yields are undoubtedly a key factor underpinning prices in other asset classes too.

But why are markets in such a breathless state about the QE experiments being conducted by Bernanke and King? I don’t know. Perhaps equity investors are looking for any form of excitement, even if it’s not based in reality.

Here’s a great chart that the Economist came up with last year. Spot the effect of Japan’s QE programme on consumer prices – if you can.

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