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As
recession fears yank commodity prices down from their recent
peaks - last week, oil and copper had fallen 20% in less than a
month - market-based inflation expectations have rapidly
declined also.
Breakeven inflation rates embedded in five- and 10-year
inflation-linked bonds, and 'five-year/five-year forward'
inflation swaps, have retreated by as much as a full percentage
point from highs in March and April, and as much as 50 basis
points since the Fed's June 15-16 policy meeting.
Inflation expectations reflected by these financial market
instruments are typically comprised of three components: term
premium, liquidity premium, and outright expected inflation.
There is no prescribed formula for slicing and dicing them, so
findings can vary wildly.
According to some models monitored by Roberto Perli and Benson
Durham at Sandler Piper, both former Fed economists, the steep
headline decline in recent weeks has been driven mainly by the
inflation expectations component, which has offset moves in
liquidity and term premiums.
Call it the 'core' measure of inflation expectations.
Durham's estimates suggest that since June 14, the eve of the
Fed's two-day meeting, the expected inflation component of the
5-year Treasury Inflation Protected Securities (TIPS) yield has
fallen around 60 basis points, and the equivalent measure in
10-year TIPS has fallen nearly 50 bps.
Durham reckons the expected inflation component embedded in
five-year/five-year forwards has declined 37 bps, helping to
reverse rise earlier this year. The year-to-date increase of
around 50 bps is still around the 90th percentile of all
six-month changes.
"The worst part has unequivocally gotten better. That is good
news," Durham said. "The decline is meaningful, but the model
can be volatile. It's encouraging though."
Such steep and rapid declines are rare. Benson notes that the
fall in five-year forwards is around the 99th percentile of all
three-week changes in absolute terms since TIPS started trading
in 1999.
The last time there was a sustained decline like this was in the
aftermath of the Great Financial Crisis. Similarly, the last
time the broader measure of five-year breakeven inflation rates
fell by a percentage point in a few months was in 2011.
GRAPHIC: Stripped out expected inflation - Piper Sandler
https://fingfx.thomsonreuters.com/
gfx/mkt/gdvzylrxapw/InflExpect4.jpg
GRAPHIC: US bond yields & inflation expectations
https://fingfx.thomsonreuters.com/
gfx/mkt/movanameypa/InflExpect1.jpg
ALL UNDER CONTROL?
This suggests investors think long-run inflation is under
control, either by an economic 'soft landing' doing part of the
Fed's work, or by the Fed deliberately making policy highly
restrictive to kill inflation (and growth).
Right now, the first scenario looks more likely. Inflation
expectations have come down but so has the Fed's so-called
'terminal rate', the market's estimate of where the fed funds
rate will peak.
At the time of the Fed's June policy meeting, rates markets were
betting the Fed would raise rates above 4% in the first half of
next year. That is now around 3.50%, and was even lower earlier
this month.
Right now, traders think the Fed won't go too far above its
long-run estimate of the 'neutral' rate of interest around 2.5%
for long, and are betting on long-term inflation of around 2.5%,
not much above the Fed's goal of 2%.
It goes without saying that too much faith must not be put in
one model. Economists, traders, and not least policymakers, will
be scrutinizing a range of indicators for signs that inflation
expectations have peaked and continue to decline.
GRAPHIC: UMich consumer inflation expectations
https://fingfx.thomsonreuters.com/
gfx/mkt/zdvxobymkpx/InfExpect2.jpg
One of those is the University of Michigan's consumer survey of
inflation expectations. The preliminary five-year June survey
rose to 3.3%, enough to prompt the Fed to suddenly shift towards
a 75 bps rate hike a few days later rather than the 50 bps move
officials had widely flagged.
The final reading was revised back to 3.1%, calling the Fed's
communications strategy and wider credibility into question.
Still, with gas prices falling - dipping below $4 a gallon in
some parts of the country - July's number could be lower still.
Many analysts point out that market-based inflation expectations
measures like breakevens and forwards are distorted by the risk
premiums embedded in them and their relatively low levels of
liquidity.
"Breakevens don't have a particularly long history. In some
instances, they react faster and earlier (to economic data), but
ultimately it is consumers' inflation expectations that matter
most to the Fed," said Francis Yared, global head of rates
research at Deutsche Bank.
GRAPHIC: US inflation expectations and oil
https://fingfx.thomsonreuters.com/
gfx/mkt/znpneadwqvl/InfExpect3.jpg
(The opinions expressed here are those of the author, a
columnist for Reuters.)
(By Jamie McGeever; editing by Diane Craft)
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