BofA Merrill Lynch head of U.S. rates strategy Priya Misra calls this her favorite chart for determining when the market expects the Federal Reserve to end its quantitative easing program: the spread between 5-year/5-year breakeven inflation expectations and 5-year/5-year real rates.
"5-year/5-year breakeven inflation expectations" refers to inflation expectations over the next five years, starting five years from now. Using 5-year/5-year rates in the calculation eliminates the influence of transitory factors arising from one-off spikes in energy prices and the like on inflation.
Movement in this spread is telling because, as Misra explains, historically there has been a positive correlation between inflation expectations and real rates, "b ecause as growth improves, normally inflation does improve – so they're both cyclical economic indicators."
When the spread is rising, then, it means that inflation expectations are for some reason outpacing growth expectations – a phenomenon which in recent years has tended to coincide with the Fed's various quantitative easing efforts.
Misra explained that this first became apparent in 2010, as the Fed geared up to launch QE2, and serves as a historical comparison for analyzing the spread today:
We found this relationship in 2010, which is when the most stock of QE2 was being priced in.
It was actually a great research exercise, because remember: with QE2, the Fed started to telegraph it way in advance. So, the Jackson Hole August 2010 [was] the first Bernanke brought it up. Then, you had a lot of speeches.
By early October, if you go back to what we were all saying, we all expected QE. I think the only question was size – and even with that, most people were in the $600-900 [billion] camp, which is why the date it was announced, we actually didn't see a big reaction in the rates market.
So, I would say it was fully priced in. So what we've done is we've calibrated that spread to that episode. (Here's how much the spread moved in 2010 as QE2 was [being] fully priced in.)
That was QE2, back in 2010. What is the spread saying about QE3 today?
Misra points out that it peaked in November, a month after QE3 was launched. At the time, fourth quarter economic data were showing weakness, and the open-ended nature of the Fed's third round of QE meant that participants in interest rate markets were still upping their expectations for how much additional bond buying the Fed had ahead of it.
Of course, the big sell-off in the U.S. Treasury market this year has been accompanied by a surge in real interest rates, so this spread has fallen sharply.
"Now, when I look at it, it's actually very little [additional quantitative easing] seems to be priced in," says Misra.
According to the spread, says Misra, interest rate markets are pricing in an additional $200-300 billion of bond purchases.
"When you end QE, that spread should actually be back to where you were when you ended, let's say, QE2," Misra says. "It could potentially be even lower, because remember: QE2 was a time period-limited program. [QE3] is open-ended."
The spread is currently at 2.15. It was right around 2 when QE1 and QE2 ended, but given the nature of QE3, Misra says its possible that it goes to 1.9.
Note: The formula used to calculate the spread charted above is 5-year/5-year breakeven inflation rate - 0.4 * 5-year/5-year real rate. The 0.4 coefficient accounts for the beta, or historical correlation between breakevens and real rates.
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