FX traders need to know whether they are following the Federal Reserve or fighting it. The trouble is, it is difficult for non-economists to decipher inscrutable monetary policy statements, Fed Open Market Committee meeting minutes and between meeting Fed-speak from Committee members.
We all know by now that the FOMC is within spitting distance of its full employment objective, and is switching focus to the inflation side of the dual mandate. Today’s inflation numbers are water under the bridge; to the extent monetary policy mattered, it was policy decisions made over the past 24 months or so that had the impact.
If you think finding your way through this tangled traffic looks tough, then you should try making head or tail out of an FOMC policy statement. Photo: Thinkstock
So as at today the FOMC – and the markets – are forward looking, reading the tea leaves to estimate how the current policy stance will influence future inflation. Yesterday’s minutes from the last FOMC meeting on October 28 to 29 contained this assessment: "Survey-based measures of inflation expectations remain well anchored, but market-based measure of inflation compensation over the next five years as well as over the five year period beginning five years ahead, had declined ... Many participants observed that the Committee should remain attentive to evidence of possible downward shift in longer term inflation expectations."
A non-economist's reaction to the above would likely be "what the hell ?".
Baffling market-based measures
The first point about “survey based measures of inflation” is easily disposed of. Last week, we saw an updated survey-based measure of inflation expectations from Thomson Reuters/University of Michigan showing medium term inflation forecasts of 2.6%, the lowest reading since 2009. Whether this implies inflation expectations are “well anchored” is open to debate. But it is the “market-based measure of inflation compensation” that baffles most people. Let’s break it down into its components. The 10-year Treasury bond today yields 2.33. The 10-year Treasury Inflation Protected Security (TIPS) yields 0.47% In TIPs, semi-annual coupon interest is paid on a principal amount that increases with inflation. So if you buy $100,000 face value today and the CPI rises 2% over the year, your principal will rise to $102,000 and the coupon is paid on that amount. And so on in future years.
Based on today’s pricing, each year the TIPS will earn investors a coupon yield of 0.47% plus whatever the CPI inflation rate turns out to be. Alternatively they can buy the conventional 10-year bond and lock in a return of 2.33%.
So you can see that for the TIPS investors to “break-even” with what they can earn for certain from buying the bond, the CPI will need to average 1.86% over the next 10 years (0.47% yield plus 1.86% CPI equals 2.33%).
So this is one of the “market-based” measure of inflation expectations the FOMC refers to. As such, it is a very useful indicator for them. Bond traders will arbitrage between the conventional security and the TIPS to reflect movements in the market’s inflation expectation.
Five-year TIPS bond appeal
But the FOMC comment quoted above refers to five years. The five-year treasury bond yield today is 1.62%. The five-year TIPS yield today is minus 0.01% This particular TIPS pays a coupon of 0.125% p.a. but the price is 100-18 1/4. Therefore the yield is negative 0.01%.
Why would anybody (apart from euro-based investors) want to buy a security that is going to pay a negative cash return over five years? Again, it is because in addition to the coupon interest, the principal amount invested will increase each year in line with the CPI. And to “break-even” with the conventional bond yield of 1.62%, the TIPS investor will need to see inflation over the next five years average 1.63% (-0.01% interest + 1.63% CPI = 1.62%). Many of the investors buying TIPS today are taking the FOMC at their word: the CPI over time will reach the 2% target and therefore TIPS will show a higher return than the conventional bond. So, based on market pricing, inflation over the next five years (to 2019) is expected to average 1.63%, while over 10 years years (to 2024) it will average 1.86%. Simple maths says then that from 2019 to 2024 the inflation rate is expected to be 2.09%, because {1.63 + 2.09}/2 = 1.86. This is the “five year period beginning five years ahead” referred to by the FOMC in the above quote.
The 5-year/5-year forward break-even rate is a closely-watched indicator in any country that has a developed inflation-linked bond market. The ECB President often references it in his press conference and speeches. In the Eurozone, it is a compilation of prices from the German, French and Italian markets. The following charts show the recent sharp decline in the five and 10-year break even rates in the US and the 5 year/5-year forward indicator for both the US and eurozone. I will address the implications of these charts in a follow up article on Trading Floor Five-year and 10-year break evens in the US
Five year/ five year forward break evens for the US and Eurozone 
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