Treasury Yields, Breakevens Reprice as Powell Nods at Inflation
(Bloomberg) -- U.S. Treasury yields beyond the two-year declined and market-implied inflation expectations retreated from multi-year highs after Federal Reserve Chair Jerome Powell said the central bank is monitoring inflation carefully and will adapt accordingly.
The two-year yield, which is more closely tied to Fed policy, briefly rose to 0.488%, the highest level since March 2020, pricing in greater odds the central bank will raise rates next year. As longer-maturity yields declined, the gap between the 5- and 30-year collapsed to about 85 basis points. That’s within a basis point of its lowest since April 2020.
Treasuries outperformed inflation-protected securities after Powell’s comments, causing market-based inflation expectations to come off the boil. Earlier Friday, the breakeven rate on 5-year Treasury Inflation Protected Securities -- a forecast for the rate of increase in consumer prices over the coming five years -- topped 3% for the first time on record. It retreated to 2.88% following Powell’s comments.
“It makes sense for breakevens to come off a bit, but the magnitude of the move is a bit surprising” because Powell’s comments don’t change the monetary policy outlook, said Zachary Griffiths, macro strategist at Wells Fargo Securities.
Rising TIPS breakevens are a sign that investors are seeking protection from consumer-price gains that exceed the Fed’s 2%-over-time target. Demand for TIPS has increased as the central bank allows inflation to run hot while the economy recovers from the pandemic. The Consumer Price Index has risen at least 5% year-on-year for the past five months, a trend Fed officials say is likely to abate as economic activity normalizes.
Related: Inflation Jump Cost U.S. Treasury $113 Billion in TIPS Payments
“It is going to be a difficult environment for the Fed to navigate, with supply chain pressures expected to persist well into next year keeping inflation elevated,” Griffiths said. “At the same time, the Fed would clearly like to see more progress on the labor market front.”
Powell, in his comments, also said it was time for the Fed to taper asset purchases but that it was too soon to raise rates. He spoke Friday during a panel discussion at a virtual event hosted by the South African Reserve Bank.
Powell said global supply-chain constraints and shortages that have led to elevated inflation are likely to last well into next year, which is longer than expected, and that as those constraints ease, it’s likely that inflation will move closer to the Fed’s 2% goal.
The risk is that the current elevated rates of inflation “will begin to lead price- and wage-setters to expect unduly high rates of inflation in the future,” he added.
“If we were to see a serious risk of inflation moving persistently to higher levels, we would certainly use our tools to preserve price stability while also taking into account the implications for our maximum employment goal,” he said.
Short-maturity Treasury yields this week touched the highest levels since the start of the Covid outbreak as inflation concerns drove traders to price in two U.S. interest-rate hikes by the end of next year.
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