Inflation Market Suggests Fed Should Slash Rates, Not Trim Them
(Bloomberg) -- The fed funds futures market is getting aggressive about a 2019 Federal Reserve interest-rate cut, with one now priced in as if it’s all but assured.
But that’s nothing compared with the message from traders of inflation-linked Treasuries. Pricing in these markets suggests Fed policy makers might need to take drastic action with monetary policy if they’re serious about meeting their inflation mandate.
The central bank’s inflation target is 2%. But the Treasury breakeven rate, or investors’ expected inflation rate as deduced from yields on various U.S. government bonds, implies this figure will languish around 1.4% over the next five years, according to Martin Hegarty, a former BlackRock Inc. managing director who recently joined Garda Capital Partners LP.
“We’re priced for one cut by the end of the year, and my view is that if this inflation profile that’s priced by the market turns out to be correct, we need to price in more,” said Hegarty, a fixed-income portfolio manager specializing in inflation markets.
The Fed’s preferred inflation measure, which hasn’t been at or above 2% since October, was 1.5% in the last tally. In January, the Fed cited subdued price pressures as a bar to further rate hikes, which emboldened traders to position for an easing cycle. They briefly trimmed those bets following Fed Chairman Jerome Powell’s comments in March that the factors weighing on inflation could be “transitory.”
Traders of fed funds futures are currently positioning for a rate cut of just over 25 basis points this year. Hegarty says that by the inflation market’s reckoning, the Fed may need to slash its policy rate by as much as 75 basis points. And that view may be gaining traction, as recent activity in eurodollar contracts show some bets on the policy rate falling by that magnitude by the end of 2019. Weaker-than-expected retail sales data Wednesday added further weight to bets on easing.
This super-dovish market call arises with the latest deterioration in U.S.-China trade relations, as investors have focused on the economic risks of a bitter and protracted dispute between the world’s two largest economies. Some see a hit to growth dragging inflation lower, and that view seems supported by the recent decline in breakevens.
Morgan Stanley economists say that while they don’t think weak inflation alone will persuade the Fed to cut, a 50-basis-point rate reduction is likely if tariffs stay in place for three to four months and cause a material deterioration in growth.
So far the Fed is showing no inclination for such action. Fed officials speaking publicly haven’t countered Powell’s statement in March that they’re “comfortable” with current policy, and Kansas City Fed President Esther George said Tuesday that she doesn’t see a case for a rate cut.
Economists at Goldman Sachs Group Inc. over the weekend focused on the possibility that price pressures will grow, estimating that the latest U.S. tariffs could boost core personal expenditures inflation -- a metric the Fed follows -- by about 0.2 percentage point. That rises to 0.5 percentage point if the U.S. delivers on its threat to impose additional levies. Boston Fed President Eric Rosengren voiced a similar opinion Tuesday, saying that the new tariffs, if sustained, could eventually harm growth and fuel inflation.
Hegarty’s own positioning aligns with this vaguely stag-flationary outlook, in which growth slows as inflation picks up. In his view, the prospects for slower growth and slightly faster inflation “are being mispriced by the market.” Because of that, he’s invested in short-dated U.S. real yields and inflation-linked bonds, and looking ahead to the Fed’s review of its inflation-targeting regime in June for further guidance on how committed policy makers are to corrective action.
©2019 Bloomberg L.P.