Background
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Given our U.S. GDP forecast, we expect the output gap to fall in line with what was witnessed back in 1974-75. Back then, 6-month inflation dropped from a high of 12.5% in January 1975 to a low of 4% by June 1976. Should investors be looking for the same amplitude in inflation deceleration this time? Not necessarily.
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Inflation swaps and the breakeven inflation rate (BEIR) on U.S. real return bonds (TIPS) are normally expected to follow one another quite closely. Recently, however, the two measures not only have diverged to widen their customary spread, but they seem to suggest quite different inflation scenarios. On November 4, 5-year inflation swaps were 1.35%, compared with minus 0.32% for the TIPS BEIR.
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By the looks of it, under current market conditions and the prevailing preference for liquidity, long-term real liabilities can be hedged at rather attractive terms.
