Favorite Bond Market Inflation Gauge Set to ‘Cross the Rubicon’
(Bloomberg) -- One of the bond market’s most closely followed monitors of long-term inflation expectations is suggesting that the Federal Reserve may be at risk of losing control over rising pricing pressure.
The so-called 5-year, 5-year forward breakeven inflation rate, is close to a level it hasn’t consistently held above for about seven years. It’s the second time in recent months that the gauge has flashed such a warning. In May, a similar rise prompted Brian Sack, the former head of monetary and financial market analysis at the Fed Board of Governors who had championed the use of the measure to guide policy, to join other prominent voices to warn the central bank needed to signal a policy adjustment.
While the Fed did that in June -- saying officials would begin to discuss scaling back bond purchases -- as well as last month to set the stage for a November taper announcement, an energy-price spiral and rising wages have unmoored breakevens again. With whittling down of bond-buying soon seen as a sure thing, any other hawkish Fed tilt would likely have to be around the timing of rate lift off.
“Inflation breakevens are about to cross the Rubicon,” a team of Deutsche Bank AG strategists including Francis Yared wrote in an Oct. 8 note.
“Consumer inflation expectations have now clearly moved out of the low inflation regime” and the 5-year, 5-year forward is “knocking again at the 250 basis points door,” the Deutsche team wrote. “There is enough evidence for breakevens to finally cross that Rubicon” to shift out of the post-2014 low-inflation regime.
At the start of the month, a University of Michigan consumer sentiment poll showed the median expectation for inflation over the next five to 10 years rose in September to 3% -- matching a near eight-year high touched in May.
The Fed’s own 5-year, 5-year forward breakeven rate, that Sack helped create, was 2.28% as of the central bank’s last update on Oct. 1. It reached 2.55% on May 11, it’s highest since February 2014. A similar metric developed by Bloomberg, which is updated more frequently, had risen to 2.36% as of Oct. 8 from 2.24% on Oct. 1. Treasuries trading is closed Monday for a government holiday.
The forward rate looks past some of the short-term noise that affects consumer prices and is derived from yields on five- and 10-year Treasury Inflation Protected Securities (TIPS) and plain vanilla Treasuries. TIPS are tied to consumer prices, which have historically exceeded the inflation the Fed targets -- the personal consumption expenditure index -- by about 30 to 40 basis points.
Sustained supply-chain snarl-ups are also threatening to keep inflation high, further buoying expectations and are seen forcing the Fed into an early rate liftoff in 2022.
It may take confirmation that President Joe Biden’s pending fiscal spending packages will be adopted in order to really allow bond-market inflation expectations to break even higher, Yared added in the note.
Biden’s longer-term economic proposals have stalled in Congress, with progressive Democrats withholding support for a bipartisan infrastructure package pending a deal with moderates on the social-spending bill. The White House has been trying to broker a deal that weighs liberal policy priorities against centrist concerns about inflation and tax hikes.
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