Analysing US Economic Activity – Forward Looking Inflation Analysis

This article will briefly look at financial indicators that illustrate the current and forward looking view of the U.S. economy.

1. Expected Inflation Levels 

Image Source Credit: Scott Grannis
Expected inflation levels can be calculated by taking the difference between Treasuries (Red Line) and Treasury Inflation protected securities (Blue Line) , gives you the markets expectations on inflation, in nominal terms. Before looking into what the expected inflation levels tells us, lets first break down why 10-year treasury yields have been used and what they mean.
10-year treasuries yields represent the interest paid by the US government on bonds to investors. One of the ways a government can raise capital for various spending activities is through a government backed bonds, as an investor, you can buy these bonds and in doing so you lend money directly to the government. Because this is a government backed bond, it is considered one of the safest investments, therefore it is a great tool to use for indicating market confidence. For example if the market confidence is low, you would expect treasury yields to fall as more and more investors buy bonds (remember Yields price opposite to bonds , if a bond goes up by +1 point , the Yield for that bond will go down by -1). In contrast if treasury yields begin to rise, this is a potential sign of more market confidence as investors direct flows away from treasuries and towards riskier assets that can produce greater returns for higher risk.
The second component to calculating expected inflation is taking into account the related 10-year TIPS (Treasury Inflation protected securities) , this is a type of treasury issued by the US government where the index itself is protected from changes in inflation e.g if inflation rises, the TIPS will adjust prices so that it produces real value prices. Essentially what this does is ensures that no matter where inflation goes, the purchasing power of an investors money is protected.
Theoretically then, if we take the usual 10-year treasury yields and take the difference against the TIPS, we will derive the markets expected inflation rates. You are comparing a Treasury Yield that does not protect against inflation against one that does.
So what does the expected inflation data tell us? 
Well , as clearly indicated, the expected inflation levels have rose recently , this is a good indicator of a more healthy economy. Remember that inflation occurs when there is excess money in the system , more than people would ideally like to hold, so this is telling us that there is more money in the system against what people typically tend to hold. Also as we looking at the 10-year treasury and TIPS line on the graph, note that it is started to tick up. As I explained above, this could potentially indicated more of a shift towards riskier assets, potentially illustrating greater marker confidence. The main counter argument against this analysis, is that of course individuals would be hoarding cash at the moment, beyond what they would typically like to hold when looking at the number of uncertainties. As a result we are in a wait and see situation.