Tuesday, November 3, 2009

The bipolar nature of inflation expectations

Back in July we've discussed the tremendous uncertainty surrounding longer-term inflation expectations for the US. This is not an academic exercise. Getting it wrong could swing the US economy into a deflationary spiral (similar to Japan) at one extreme or a hyperinflationary environment on the other.

The chart below from the San Francisco Fed shows just how divergent the economists' expectations have become.

What's unprecedented about this divergence in inflation outlook is that it also shows up in the market. The following chart shows weekly prices for GLD (a gold ETF) and IEF (iShares medium term treasuries ETF) for the last few months. A rally in gold in a normal market should correspond to declines in treasuries. But here we see stability in the treasury market in the face of rising gold prices.

This is an indication of an almost bipolar market that is betting on price stability (even deflation) from credit contraction and continuing unemployment on one hand and accelerating inflation on the other. It's hard to see both occurring, simply because slow economic growth (or further contraction) in the US can not sustain significant price appreciation due to weak demand. Over time something has to give - either commodities have to sell off or longer term rates have to come up.

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