Is there a difference between inflation or reflation, and whatever this is? Not mere semantics, it may be everything for any material distinction. Yet, the only one ever talked about is the first, as if a foregone conclusion. Why?

We’re conditioned to believe in only one or the other, recession still contracting or otherwise total recovery, on top of never questioning whatever it is the Federal Reserve may be doing:

We’ve been left with the impression that the economic situation is always binary; the economy is in recession or recovery/growth. No other choices. Believing this, everything becomes a simple matter – including the most important part. In other words, all you have to do during contraction is wait for it to end. If there are only the two options, once an economy’s reached its ultimate trough all worries can be set aside.

The public should know this is just not true because it hasn’t been. Furthermore, we’ve already been through this process. And not just recently, as recent as a few years ago. That was actually the third bid for inflationary acceleration presumably formed by the combination of successful monetary and fiscal policies. The only difference between that one and the prior two was the unusual conviction from which it was sold to the public.

Its most prominent sellers have since completely changed their tune; quietly, of course.

Let’s begin with what should happen if the inflation scenario was beginning to play itself out. The first place you’d see it is in the bond market. And that’s where inflation expectations have been rising. In fact, the 10-year TIPS breakeven moved above 200 bps today for the first time in several years. The 5-year is nearly at that the same point.

While inflation expectations are a necessary condition, there are, by themselves, nowhere close to sufficient. To start with, TIPS pays investors based on the CPI and the CPI over the last decade has been moved around by WTI alone rather than WTI plus anything else. If there was an inflationary recovery on the horizon, and investors believed it was a realistic possibility, then inflation expectations would imagine TIPS holders getting paid by more than supply factors in Cushing, OK.

Bouncing up and down by oil prices only proves the economic deficit; that there isn’t anything other than crude to provide that government-funded benefit. An inflationary period is one where real economy opportunities are widespread, never concentrated so narrowly. Sure, TIPS benefit from oil but the CPI would be accelerating for these many other factors.

What that would mean is rising nominal yields, too. Given where the yield curve is now, steepening right from the start.

And while the curve has become somewhat steeper, it’s only because of how things are going at the short end. The 2s10s part of the curve, for example, has decompressed to 82 bps at the start of 2021 – the steepest since October 2017.

Over the past two months, however, that steepening has been a product of the rate on the 2-year Treasury falling while that for the 10s has barely budged. Despite vaccine-aphoria being introduced into crude in a small way, therefore TIPS, the rest hasn’t gone alone.

The TIPS rate along with a minimally higher 10-year is declared proof positive the Fed has been successful at its inflation engineering when there’s everything here (including oil, too) to contradict that assessment.

To begin with, the other part of TIPS no one ever talks about. Real yields. Because nominal Treasury rates haven’t moved all that much, the rise in oil prices, particularly the post-vaccine move, has had to come at the expense of so-called real rates. This changes the interpretation entirely.

Both the 5-year and 10-year real rates have fallen dramatically, staying down despite all these recent “positive” developments which are said to be economic game-changers. In fact, the real 10s yield is equal today to its lowest on record while the 5s are mere bps from their own.

What does that mean? No recovery, no inflation. Rather, TIPS are being moved higher by expectations for the CPI to be better, on average, because of higher oil prices alone. The economy itself, which is what would produce actual inflation – sustained, broad-based increases in all consumer prices not just one or a few commodities – is being priced simultaneously as if prospects for the intermediate and longer terms have changed very little.

In other words, a woeful economic situation which would be made worse (more miserable) by rising crude.

This isn’t surprising given the situation in commodities – and not just those for WTI. A combination of vaccine-aphoria with drastically reduced supply (and supply potential, as in copper), it’s an ironic situation of apparent and widely-cited inflation being driven by realized deflation in those places. As economic activity in mining has been depressed, commodity and other prices have been squeezed higher for the lower levels of output.

That, along with lower anticipated economic output across the entire global scene, is why nominal Treasury yields haven’t budged since March and therefore real yields sink to unbelievably low – and deflationary – levels.

TIPS investors are expecting to get paid on WTI – and nothing else at the moment. In fact, real yields say that the TIPS market is thinking a little more in oil might make up for even less real economy inflationary outcomes.

Thus, the rest of the bond market beyond Treasuries has been equally flaccid and unmoved by the renewed hysteria. Swap spreads, a big one, continue slightly higher in the 30s while nearer in towards the important belly indications they’ve been even a tiny more compressed (disinflationary).

All of this stands in sharp contrast to Reflation #3 in 2017-18 and its major contribution in the form of Inflation Hysteria #1. At least in late 2017 into the first months of 2018, nominal yields were rising, at times sharply, as had swap spreads and particularly real TIPS.

Unfortunately back then, the difference between an inflationary recovery and just reflation as it had been was, among other factors, the yield curve itself flattening out. For as much as the bond market had moved and reshaped itself in some of these ways the right ways, even then it was never a full-throated endorsement; therefore, only ever modest reflation.

Inflation expectations right now are the highest in years while at the same time real economic expectations, produced from the very same instruments, are at or nearing record lows. It seems like a contradiction only in terms of WTI and even then only in terms of thinking crude oil prices are entirely about surging demand.

In fact, demand right now is far from surging (above), meaning that the only inflationary signal in the whole bunch is WTI being pushed upward on hopes that vaccines will make all the difference; if they are distributed wide enough, and are effective enough, to end the current recession and bring about actual recovery.

It’s a huge amount to be laid down all on just the one factor; it’s not even a today factor, as with Inflation Hysteria #1 it’s a hope that tomorrow will finally be different though right now is materially less than 2017-18 had ever been. 

One of these days recovery will be true, but when it does come it won’t look anything like this.