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INFLATION EXPECTATIONS COLLAPSE AMID SLOWING ECONOMIC GROWTH

INFLATION EXPECTATIONS COLLAPSE AMID SLOWING ECONOMIC GROWTH

Courtesy of Rom Badilla of Bondsquawk.com

Inflation expectations as indicated by the yield differential between 10-Year Treasuries and 10-Year Treasury Inflation Protected Securities (TIPS) continues to decline.  The decrease is attributed to a decline in inflation concerns fueled in part, by the drop in today’s release by the Institute for Supply Management manufacturing activity data.

The manufacturing sector growth is showing signs of slowing.  ISM reported its manufacturing index declined to a reading of 56.2 in June from a print of 59.7 in the prior month.  Today’s release disappointed economist expectations of 59.0.  While the June figure is still showing economic expansion since a reading above 50 indicates growth, today’s release is the 2nd consecutive drop after peaking in April at 60.4.  Equally important is the decline in the ISM Prices Paid component which is having a huge effect on inflation expectations.

Several weeks ago (posted here), we discussed that the Prices Paid component of the Philadelphia Fed Business Outlook Survey Index (released June 17) dropped significantly from a May reading of 35.5 to 10 signaling easing pricing pressures.  By charting the prices paid component to the breakeven rate, we can see a correlation between the two. The two exhibits a 0.79 correlation where a reading of 1.0 suggests a direct step for step relationship and -1.0 indicates an inverse relationship. A reading of zero suggests no relationship at all. A decline in the prices paid component reading suggests falling inflation expectations and even lower bond yields.  As posted on June 23rd, several days after the Philly Fed release, we concluded that given the level of the prices paid component, the breakeven rate could fall 20 to 30 basis points.  Furthermore, given that the 10-Year was trading at 3.10-3.15 percent at that time, a decline in inflation expectations could point to a “10-Year Treasury yield of sub-three percent, reaching or even surpassing recent lows”.

In similar fashion, today’s release of the ISM’s Prices Paid component confirms our concern of lower inflation readings and hence a lower breakeven rate.  The ISM Prices Paid component (which is highly correlated to the Philadelphia Fed Prices Paid component by 0.87 over the past 10 years) dropped to a reading of 57.0 from 77.5 in the prior month.  Today’s lower print further disappointed economists as surveys were at 70.0.

2010 07 01 ISM PP 300x214 INFLATION EXPECTATIONS COLLAPSE AMID SLOWING ECONOMIC GROWTH

ISM Prices Paid Index – Historical Chart (Monthly Observations)

The yield differential aka breakeven rate is currently at 176 basis points, a decline of 8 from yesterday’s close.  Since our observation on June 23rd, the breakeven rate has dropped 20 basis points, reaching our initial estimate.  During that time, the 10-Year Treasury has tightened an equal amount and now stands at 2.92 percent.

2010 07 01 BE 300x214 INFLATION EXPECTATIONS COLLAPSE AMID SLOWING ECONOMIC GROWTH

Inflation Expectations aka Breakeven Rate – Historical Chart

2010 07 01 GT10 300x214 INFLATION EXPECTATIONS COLLAPSE AMID SLOWING ECONOMIC GROWTH

10-Year U.S. Treasury Yield – Historical Chart

We know that much of the growth in the first half of the year was fueled by federal stimulus packages, which unless new legislation is enacted (which is unlikely given the calls for global austerity measures) should dissipate in the 2ndhalf of 2010.  Hence, much of the growth in manufacturing activity from the first half should begin to wane and cripple economic growth.  With less activity, resource slack should increase, which in turn, lead to further decreases in price pressures and lower inflation expectations.  Given this construct of slower future economic growth and inflation expectations, a weakening unemployment picture could accelerate us further in that direction.  While we have reached our initial aforementioned target on both the breakeven rate and 10-Year Treasury which could lead to a short-term bounce, further declines appear to be in the cards for the remainder of 2010. 


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