Thursday, April 20, 2006

Doveish Fed Comments Raises Inflationary Expectations

Although gold prices fell today, they have still increased sharply in recent days. One of the reasons for the gold price rally is likely higher inflationary expectations. During the recent gold price rally, the spread between the yields of regular bonds and inflation-procected bonds, so-called Treasury inflation-protected securities (TIPS), have only increased slightly as TIPS yields have increased almost as much as yields from regular bonds. This could indicate that the gold rally is driven by other factors than higher inflationary expectations, although it likely also partially reflects a divergence between the inflationary expectations of bond traders and commodity traders and possibly also a belief that government inflation statistics (which is what is relevant for the spread between regular bonds and TIPS)is manipulated to underestimate inflation.

But during the gold price rally this week, we can clearly see that this reflects higher inflationary expectations. Last week, when the yield on the 10-year Note rose from 4.97% to 5.05%, the TIPS yield rose nearly as much, from 2.41% to 2.48%, meaning that the spread only rose from 2.56% to 2.57%. Yet when yields on the regular 10-year security fell from 5.05% to 4.99% the first two days of this week following doveish comments in the minutes from the latest FOMC meeting, the TIPS fell even more, to 2.38%, raising the spread to 2.61%. And when yields rose again to 5.04% following higher than expected "core" inflation numbers and sky-rocketing commodity prices, the TIPS yield was unchanges, raising the spread to 2.66%. This indicates that an increasing number of bond traders now believe that the Fed is going to inflate more than previously expected. A rational belief, in my view. Indeem I think the 2.66% spread is far too small. While I wouldn't recommend anyone to buy any U.S. government securities even after the recent increase in yields, it is far more rational (less irrational) to buy TIPS rather than regular securities.


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