Thursday, September 13, 2012

Longer-term inflation expectations spike in reaction to the Fed

Last Friday's action (discussed here) indeed turned out to be a good indicator of how markets in the current environment would react to Fed's balance sheet expansion. Markets performed as expected: commodities and equities spiked, the dollar weakened, and the treasury curve steepened.

The MBS purchases the Fed has promised today (discussed here) will result in taking out medium to shorter duration paper out of the market. Even your average FNMA 30y 3% coupon bond has a duration of 6-10-years - depending on treasury yields.

Source: Bloomberg

That means QE3 purchases will not directly impact longer duration bonds (at least not as much as the 5yr notes). The longer term part of the curve will therefore be driven by inflation expectations. And longer term inflation expectations, as implied by the TIPS yields, rose sharply today.

10y inflation expectations (10y breakeven)

The combination of the Fed's expected shorter duration purchases and longer term inflation expectations forced the treasury yield curve to steepen. The market is beginning to price in rising inflation and there is only so much negative real yield investors will tolerate.
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