At least since 2003 (which is when our data on TIPS begins), the dollar and breakeven inflation expectations have had a negative relationship. Said differently, when the dollar strengthens (as it has done recently) inflation expectations tend to fall and vice versa. A strong negative relationship has been especially true since 2010 when the correlation between the USD index and 10-year TIPS implied breakeven inflation has increased to a robust -80%. We know, of course, that in the short-term strong relationships can break down and sometimes completely reverse. This type of complete reversal is what has occurred since this summer. Since 6/30/2016, the correlation between the dollar and inflation expectations has skyrocketed to +92%. So the dollar has gone up AND inflation expectations have increased as well step for step. Ultimately, we believe that these two series will likely revert back to the more traditional relationship and the “gap” that has opened up in the first and second chart below should close (note: the USD index is inverted in all the charts below). A similar episode, granted to a much lesser degree, occurred at the beginning of 2015 and by August 2015 the dollar and inflation expectations had synced back up. To us, a similar reversion to the norm seems like the most probable outcome at the moment.
Article by Eric Bush, CFA – Gavekal Capital Blog
