TIPS continue to shred it, with breakevens up another 15 basis points this week. TIPS have outperformed similar maturity nominal Treasurys by 4% since August 24^th as investors seek the safety of inflation protection going forward.

The spread between the yield on 2- and 10-year Treasurys is commonly used as a proxy for inflation, but the 10- to 30-year spread is gaining traction in the market as it grows. Some of this is attributable to lack of attention 30-year bonds stand to receive from the Fed during QE2, but longer term inflation expectations are pushing this spread out further. The spread currently stands at 141 basis points, up from 106 beeps at the beginning of September. The market will keep a close eye on this number going forward.

In other inflation news, the commodity index, CRB, traded over the 300 threshold for the first time since Oct 2008. This is another number that will become increasingly important if commodities continue to run.

I’m Feelin Queasy

I wrote last week about how the Fed has backed themselves into a serious corner when it comes to the next round of Quantitative Easing. QE2 remains the biggest story on the street, and will continue to dominate market action until its details are revealed. Bernanke spoke today at the Federal Reserve Bank of Boston and used the opportunity to continue to pave a clear path for future monetary easing.

The usual suspects for further action haven’t changed. In addition to QE2, the Fed will continue to lean heavily on the language used in the FOMC statement, (i.e. extended period). Some rumors were floating around last week that explicit interest rate targets would be used by the Fed, but I didn’t hear Bernanke say anything about that as a possibility today.

Back to QE2 - Inflation will be a larger part of the discussion going forward, not because economic fundamentals are looking broadly better, but because QE2 will bring us further into unchartered territory. The money that the Fed will pump into the system will sit fallow in excess reserves, doing nothing but earning banks .25% while they leave the cash in the vault at the Fed. Those thinking that this incredible amount of liquidity will never be a problem are relying on the FED to tighten before the damage is done, which is a very unlikely scenario.

While opening the door to future stimulus, Chairman Bernanke admitted that there are large uncertainties about the true benefits of bringing longer-term interest rates lower. Many argue that what the Fed faces now is a liquidity trap, where further increases in the money supply do nothing for long-term interest rates, and therefore fail to have any stimulative effect.

Liquidity trap or not, QE2 is on its way, perhaps as soon as next month’s FOMC meeting. Bernanke’s speech today shed good light on the Fed’s commitment to inflating our way out of a truly dire situation, (deflation), in favor of higher than average rates of inflation to help in the deleveraging process.

Have a great weekend.

Cliff J. Reynolds Jr., Investment Analyst