Little remarked in the press has been the reversion of the 5-year TIPS to a yield below equivalent maturity conventional treasuries. According to Bloomberg‘s bond page, the 5-year TIPS yield is currently 35 basis points below the conventional 5-year Treasury. This is significant because for several months, the yield of that TIPS issue was above the yield of the conventional treasury — and this was widely cited as evidence of expected long-term deflation. A better analysis (okay, that means mine) shows that this was never the case — TIPS, whose inflation index lags actual CPI by 3 months, were really never implying long term deflation in the future. Rather, they were reflecting the bursting of the commodity bubble that occured in the past.
The chart of the Reuters Jefferies CRB Index show the steep decline of commodity prices since July. Over short periods, commodity prices (energy in particular) exert a large influence on CPI. TIPS investors, looking back, knew with certainty that the maturity value of their TIPS would decline as the 3-month lag factor worked in (via changes in the index ratio that determines maturity and coupon values). Those investors responded by incorporating this into pricing, driving TIPS down to a level where their yield exceeded conventional treasuries, which many mistook for a signal of long-term deflation.
As the chart shows, commodity prices have now been stable for nearly 2 months. As this flows into CPI (lag #1) and then flows into the index ratio which adjusts TIPS (lag #2), the bond pricing will start to reflect true inflationary expectations, not the past. From the standpoint of appearances, the TIPS will appear to have flipped from deflationary to inflationary expectations, when in reality, nothing has changed.
Given the extreme measures that are being taken in the name of fighting a deflationary spiral, I vote that instead, we simply declare victory in the war on deflation and go home.