Breaking Down Breakeven Rates Part 3

Now that we know how breakeven rates are calculated and what they represent, we can finally answer the question that launched us down this rabbit hole – what kind of inflation is currently being priced into breakeven rates?
Considering that the focus of the “boom times” narrative is on inflation, and the part of the breakeven rate calculation that involves inflation is the TIPS yield, that is the natural place to go looking for answers. (Note that UST yields also have a component that is affected by inflation expectations)
Furthermore, having established that TIPS yields are driven by investors expectations of what the CPI will be doing, it follows that whatever is driving investor perceptions of future CPI levels is also driving the rally in breakeven rates.
So what is this mysterious driving force?
The unfortunate, and very anticlimactic truth is that no one can say for sure, simply because of the complexity inherent in how markets work. BUT, there are always a few chief suspects, if not one main suspect. In this case, that would be supply headwinds in the US oil patch.
Why would oil be the main suspect? Because changes in energy prices feed very quickly into the CPI with very little lag time. In addition, the recent cold snap in Texas exacerbated already tight supply conditions, contributing to even higher global oil prices as power cuts rolled across the state.
However, buying TIPS to protect capital from rising energy prices is not the same as buying TIPS to protect against a rise in prices due to robust economic growth. The former scenario presents an economic dilemma, because rising energy prices are inimical to robust economic growth, especially in an environment where the labor market is still suffering and really struggling to regain its footing.
More expensive energy cuts into consumers’ disposable incomes, taking away cash for other purchases. It also increases the cost base of corporations whose customers are struggling to hold on to, or even have, monthly incomes.
The latter scenario, on the other hand, is where energy prices rise due to robust economic growth, and is an environment which lifts almost all parts of the economy, including consumers and the labor market. Today’s labor market, which is still haemorrhaging jobs, definitely does not count as such an environment.
This is where people who buy into the “boom times” narrative conflate the two scenarios, and therefore misconstrue the nature of the rise in breakeven rates. In their minds, the inflation caused by the rise in oil prices is part of incoming robust economic growth due to QE (which does not work) and fiscal stimulus (which also does not work as expected).
However, higher breakevens can mean higher inflation without robust economic growth. Higher oil prices do not always equate to an overheating economy.
So, what kind of inflation is being priced into breakeven rates? The not so good kind, that’s what.
To be concluded…
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