Wednesday, June 16, 2021

Inflation surprises and the expectation catch-up in 2021


 

It is not just inflation that is important but inflation surprises. In fact, the surprises usually have a more significant impact on asset returns. Most of the research on inflation and asset prices notes that the responses of asset classes with respect to actual inflation, expectations, and surprises are different. Asset prices are forward-looking. Inflation is backward-looking. Expectations and surprises generally matter more. 

A simple method for looking at inflation expectations is to track the Treasury breakeven time series. Note that the 10-year Treasury break-even is a long-term measure for expectations of inflation over the next 10-years. The 5-year Treasury breakevens provide a shorter-term outlook. Both have peaked albeit real rates are still declining. 

We compare Treasury break-evens versus a moving average of break-evens to measure inflationary surprises. Surprises have been both positive and negative over the last decade with a large negative spike in March 2020 from the pandemic. We measure the cumulative error to account for the direction of surprise and the catch-up. If adaptive expectations were unbiased, the cumulative error would center around zero.

It is noticeable that after the pandemic shock, inflation expectations rose and showed a positive surprise. The cumulative error or surprise moved from negative to positive levels. Break-evens have peaked and actually signal that inflation expectations are moderating which suggests that the transitory inflation story may be the base case.  




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