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VIDEONews Flash: Inflation to Drop in Five Years
There's an inflation swap market for what inflation will be for a five year period starting five years from now; but it's not about predicting so much as it's about providing a trading instrument where dollars can change hands.
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While you're pondering that, let’s turn our attention to another one of those esoteric indicators designed to separate the cognoscenti from the riff-raff, forward-starting inflation rates. There's an inflation swap market for things such as what will inflation be for a five-year period starting five years from now; known as the five-year/five-year, it produces much thoughtful introspection amongst people who, if they lived in Mao’s China, would be sent out to the countryside to do something socially useful such as clean the hogs’ latrine.
Five-year/five-year; give me a break. I really want to see the list of people who in August 2005 predicted any of the major moves we've seen individually, much less in conjunction. But these markets aren't about prediction so much as they're about providing a trading instrument where real dollars, should any of those actually exist, can change hands once the settlement periods start five years from now.
Look Out Below
Even if these markets don't prove correct in their eventual assessment of where the CPI will be, they do a good job of measuring where current expectations are. We can construct five-year/five-year markets from the forward rate between on-the-run five- and ten-year TIPS, a measure we can take back to the start of 2002, or from the forward rate between five- and ten-year inflation swaps, a measure we can take back to November 2004. Those measures can be mapped against actual year-over-year changes in the CPI led five years.
Both forward-starting inflation measures started collapsing this past spring. Is it any accident this is when the present bond rally started to take off? If you start to price the risk of inflation out of long-term bonds, the yields on those bonds fall; the question of whether the market is any better in its assessment than a Roman entrails-reader or some blue-painted Druid priestess is irrelevant.
Time For DIPS
On second thought, let’s go back to the question above whether Uncle Sam should sell deflation-protected securities. As any designer of financial products can tell you -- but few will -- you need a story to sell the product. The US Treasury is the largest debtor and therefore has the most to fear from deflation, so it needs to declare another war on deflation and enlist the support of you, the patriotic citizenry. Sell the chumps, er, patriotic citizens doing their part zero-coupon DIPS that will pay back at par if the CPI rises and will pay a taxable accrual on declines in the CPI. In other words, borrow at 0% and never pay them anything.
If this scam, er, financial product grows to the size of the TIPS market, fudge the CPI so that the Treasury’s net payout on the accrual will be $0 before tax and negative after tax. Sound far-fetched? Have you checked the economics of Social Security recently?
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