Tuesday, June 2, 2009

Where inflation expectations go next will be just as important.

TO BE NOTED: From the FT:

Short View: Inflation expectations

By John Authers, Investment editor

Published: June 2 2009 17:52 | Last updated: June 2 2009 17:52

Some markets are back to normal. Whether they have been brought there by any normalisation of sentiment is another matter.

On Tuesday, the market’s best guess at the US inflation rate over the next 10 years, formed by comparing the yields on inflation-protected and fixed-income government bonds, reached 2 per cent. The last time inflation expectations were this high was the week before the Lehman collapse last September. In the aftermath, inflation expectations went negative, implicitly predicting deflation on a scale not seen since the Great Depression.

That scare is over, but a new inflation scare is not yet here. For the five years before Lehman, traders believed in a “Goldilocks” (not too hot, not too cold) economy, and expectations ranged between 2 and 2.75 per cent. So 2 per cent suggests a benign outcome, dodging the twin fears of deflation and hyperinflation.

Emerging market debt also now appears to have completed a trip back to normal. JPMorgan’s EMBI+ indices show that emerging Asian sovereign debt now trades at the same spread over US treasuries as it did the week before Lehman – having tripled in the interim.

The market believes (quite plausibly) that last year’s emerging market debt crisis was a temporary phenomenon resolved by help from the US Federal Reserve, and the International Monetary Fund.

Mr Market’s expectations for inflation are harder to categorise. Few believe that Goldilocks will return. Rather, the market expectation is formed by forecasts ranging from fear of hyper-inflation to a belief that the banking crisis could yet force deflation.

The move back to 2 per cent shows that last year’s acute liquidity crisis is over. This is a vitally important step. Where inflation expectations go next will be just as important.



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