Diverging Fortunes

The US 5 year breakeven rate tells us the market’s expectation for US inflation over the next five years, based on the difference in prices of inflation-linked (TIPS) and nominal bond yields.

It has crashed this week, now signalling expected inflation of around 1.3% each year. This is generally an indication that monetary policy is too tight; the markets were expecting the Federal Reserve to make a credible commitment to loosen monetary policy (for example, with more QE), but instead it has decided to fiddle around the edges with “Operation Twist”.

You can see from the graph below how inflation expectations have fallen since returning to more healthy levels after the “QE2″ program started in November 2010:

US 5 Year Breakeven Rates. Source: Bloomberg

The current forecast of course matches what the equity markets are saying: a long period of economic gloom.

Curiously, whilst the equivalent UK breakeven rate had also been falling up until the beginning of September, the trend has now diverged from the US.  Expected RPI inflation over the next five years has risen to 2.3%, from a low of 2.2% at the beginning of the month:

UK 5 Year Breakeven Rates. Source: Bloomberg

As UK “linkers” are priced off RPI not CPI, with the latter being typically 0.5% to 1% below the former, this implies CPI inflation is expected to average below 2% for the next five years.  So we could reasonably expect that the Bank of England will ease monetary policy soon to be able to meet the 2% target.  This was corroborated by the minutes [PDF] of the Bank of England’s Monetary Policy Committee meeting on September 7th, which were published on Wednesday this week:

For most members, the decision of whether to embark on further monetary easing at this meeting was finely balanced since the weakness and stresses of the past month had significantly strengthened the case for an immediate resumption of asset purchases. For some members, a continuation of the conditions seen over the past month would probably be sufficient to justify an expansion of the asset purchase programme at a subsequent meeting.

Without wishing to indulge too much in schadenfreude, the hopes for the UK economy may not be quite as dire as the outlook for the US.  Will equity investors take note?