Inflation: The Game Has Shifted From Limbo to Hurdles

For the past several decades, investors have generally been playing limbo with inflation. No matter how much they lowered their expectations, somehow inflation seemed to squeeze under the bar. The limbo dance could be over. Investors should now realize inflation expectations are set very low and inflation seems increasingly likely to hurdle that very low bar.

Whenever one hints at an increase in inflation, one is immediately asked how high inflation might go. However, that’s the wrong question.

Investors should ask “what’s the probability inflation could be higher than expected?”

Consensus inflation expectations are roughly 2% (based on TIPS break even rates), so the pertinent question is what is the likelihood that inflation will be higher than roughly 2%. We think jumping that hurdle is currently much easier than investors believe.

The game has shifted from limbo to hurdles.

Breakevens on the rise

TIPS breakevens, or the implied inflation rate that equates TIPS1 to nominal Treasuries, has been rapidly rising of late. Of course, some of the increase is simply attributable to the increase in economic activity subsequent to the pandemic shutdown, but it is likely attributable to other factors as well.

Production bottlenecks have appeared in the global economy, US wages are rising at a fast pace, unionization may be increasing, import prices are no longer fostering deflation, and record US money growth seem to suggest the upward trend in breakevens might not be quite as temporary as some believe.

Five-year breakevens have rebounded sharply and are now the highest in eight years.

TIPS 5-Year Breakeven
(Jan 28, 2010 – Jan 21, 2021)