Recap 11-5-12: US Inflation Breakevens are Too High


With commodities prices falling across the board, and with growth expectations tepid, one would expect that inflation expectations would be low as well. However, this is not the case. At ~2.5%, US 10y inflation expectations remain at the highest level since early 2011. Almost all of the inflation fears, however, are for maturities more than 5 years out. 1 and 2 year zero coupon inflation swaps are 1.4% and 1.75%, respectively. Comparatively, the 5y5y zero-coupon inflation swap is at 3%. The chart below comparing 10y break evens (orange) and the ISM (white) highlights the dichotomy:

There are two possibilities that I can think of that could explain this dichotomy. First, the FOMC has said that they essentially will allow a higher level of inflation. Second, the market may be extrapolating recent positive housing data to a sustained increase in the growth rate of the Owner Equivalent Rent component of CPI. Neither of these explanations, however, appears complete.

First, even though the FOMC may tolerate higher inflation, actually getting it is another story. The slack in the labor market and the upcoming fiscal retrenchment all suggest that inflationary pressures, albeit not fears, will remain contained. As a result, if this factor is the main driver of the dichotomy, the dichotomy should fade over time as the fears of inflation do not materialize.

Second, a close examination of housing data will show that tightness in housing markets is NOT widespread and certainly not as widespread as the 2004-2006 period, when OER inflation touched 4.3% YoY, vs 2.1% now. Note that even then, 10y break evens did not trade much higher than 2.6% for long.


  • US Non-Mfg ISM declined to 54.2 in Oct vs 54.5 exp and 55.1 prev
  • UK services PMI declined to 50.6 vs 52 exp and 52.2 prev
  • EU Sentix investor confidence increased to -18.8 from vs -21 exp and -22.2 prev
  • China Non-mfg PMI increased to 55.5 in October from 53.7.
  • China HSBC services PMI declined to 53.5 in October from 54.3.
  • Asymco notes that Smartphone adoption in the US has already hit 50%. Over the past 12 months, Android captured 58% of the growth vs 42% for Apple. Windows Mobile continues to lose market share:

Upcoming Data:

  • Mon: ISM Non-Mfg PMI, RBA
  • Tues: Italy Services PMI, US Election
  • Wed: Swiss CPI, Japan Current Account, Australia Employment, Japan Eco Watchers Survey
  • Thu: BoE, ECB, US Jobless Claims, China CPI
  • Fri: China IP, Retail Sales, US UMichigan Consumer Confidence