Inflation Expectations

5Y/5Y Forward Explained

We often hear the term inflation expectations, but many might wonder where exactly do they get that data and what is it telling us today? Do they get it from surveys or some sort of forward forecast of past data? No, it comes from the 5-Year, 5-Year Forward Inflation Expectation Rate. This is the metric that is widely regarded as inflation expectations and can be used for all major economies separately.

The 5Y/5Y forward uses the difference in market interest rates for a period of 5 years, beginning 5 years in the future. In general, you subtract an average of 5Y bonds from an average of 10Y bonds. Currently, in 2020 we take actual market interest rates with a maturity date of 2030 (10Y bond issued in 2020) and subtract the rates for 2025 (5Y bond issued in 2020).

It’s not exactly that simple, but close. For those who are interested in the formula to calculate the 5Y/5Y Forward, you can find it on the Fred website linked above, and is written as follows.

( ( ( [(1+((BC_10YEAR-TC_10YEAR)/100) )¹⁰] / [ (1+((BC_5YEAR-TC_5YEAR)/100) )⁵] )⁰.2) -1)*100

where BC10_YEAR, TC_10YEAR, BC_5YEAR, and TC_5YEAR are the 10 year and 5 year nominal and inflation adjusted Treasury securities.

What the 5Y/5Y forward is telling us today

You might think with all the news of “Biblical floods” of money printing that inflation expectations are off the charts. Inflationists everywhere are telling us that the end of the dollar is nigh and that inflation will be the killer. Even most bitcoin investors see inflation of the dollar as the only route that will end its dominance, making it ripe to be taken over by bitcoin.

They are all wrong. The global economy is stuck in the grips of an overindebted deflation. Money is credit and credit is not expanding, therefore no inflation. It doesn’t matter how you slice it.

What is the 5Y/5Y forward rate telling us?

At first glimpse of the chart, we can see the two dips around the two recessions, the Great Financial Crisis (GFC) and the 2020 Recession. But what else can we see? The current inflation expectation rate is less than 2% AFTER 12 years of “money printing!?” In fact, it is lower today than almost any other period in the last 12 years!

We can see a consistent move lower for the last 8 years. Even after the Fed pulled out all the stops, in the forms of: QE1–3, Operation Twist, hundreds of billions of dollars in foreign bank currency swaps, buying corporate securities, and QEternity, investors with skin in the game, putting their money where their mouth is (into the sovereign bond market), are telling us inflation will not even exceed 2%!?

The only time, since the GFC, where we had lower inflation expectations was briefly in 2016. How is that possible if QE and fiscal stimulus are inflationary?

It’s not.

Originally published at https://btcm.co on November 17, 2020.