(Bloomberg) – Goldman Sachs Group Inc. and bond titan Pacific Investment Management Co. have a simple message for Treasury traders worried about inflation: Relax.
Companies believe bond traders who estimate annual inflation close to 3% over the next several years are overestimating the pressures that are mounting as the US economy rebounds from the pandemic.
Add to that some technical distortions in the way market-based inflation expectations are valued, and Goldman Sachs, for its part, says the overshoot could be as high as 0.2 to 0.3 percentage point. This spread is making a difference, with key market indicators of inflation expectations reaching their highest level in more than a decade for shorter maturities.
There is at least one market metric that confirms the idea that the pressures are not so out of control and may even turn out to be temporary. A swap instrument reflecting the annual inflation rate for the second half of the next decade has been relatively stable in recent months.
The inflation debate is crucial as policymakers and investors navigate the recovery from the pandemic. The Federal Reserve has insisted that it considers any increase in price pressures to be likely short-lived and that it is prepared to let inflation exceed target for a period of time as the economy recovers . Now he seems to be taking a break from his campaign. Not only are Goldman and Pimco making the case for a more benign inflation outlook, traders have also lowered their bets on rate hikes by the end of 2023, even in the face of strong economic data.
“We don’t see the kind of inflationary pressures the markets seem to fear, and high growth rates won’t necessarily translate into a higher rate of inflation,” said Praveen Korapaty, chief interest rate strategist. at Goldman.
Market measures known as the break-even rate, which stem in part from inflation-protected Treasury securities and represent expectations of annual consumer price increases, surged again this week as the reopening of major industrial economies was progressing.
Inflation fears have grown amid soaring commodity prices – copper, for example, is near an all-time high. All of this is happening as lawmakers in Washington debate yet another massive fiscal stimulus package.
But it’s worth noting that the two-year breakeven – which hit an almost 13-year high of nearly 2.9% on Wednesday – is significantly higher than traders’ expectations in the second half of the coming decade. This shows that the market is positioned so that price pressures will eventually abate.
Korapaty calls the outlook for inflation “benign,” even though his company is one of Wall Street’s most optimistic growth forecasters. According to him, the market is overly optimistic about its inflation assumptions, with the biggest lag being in the three and five year horizon. At around 2.8% and 2.7%, respectively, those rates are about 20 to 30 basis points higher than they should be, according to his estimate.
A measure of annual inflation that excludes food and energy costs, at 1.8% in March, could climb to 2.4% to 2.5% this year, a level last seen in 2007, but the bump will likely be brief, Korapaty said.
“If we’re right and the inflation readings come out, we might be tempted to cut Fed prices and consider markets may pull back when pricing the Fed take off,” Korapaty said. Plus, he says, this would be a good time to sell three-year breakevens.
The intensification of discussions on price pressures comes amid unease in the markets and in Washington over the scale of fiscal stimulus. On Tuesday, Treasury Secretary Janet Yellen stirred the markets by saying that interest rates are likely to rise as government spending rises and the economy grows faster. She returned to the remarks hours later.
The Fed has indicated that it intends to maintain an ultra-flexible policy at least until 2023. In August, it adopted a new approach that allows inflation to exceed 2% longer before raising prices. rate. The aim is to bring inflation down to 2% on average over time, to compensate for past deficits. The Fed has failed to achieve this level consistently for much of the past decade.
Certainly some on Wall Street are more concerned about the risks of inflation. Marko Kolanovic, chief global markets strategist at JPMorgan Chase & Co., warns some fund managers are facing an “inflationary shock” on their portfolios.
Futures forecast the Fed to take off in the first quarter of 2023, which is sooner than officials expected. While the market timeline hasn’t changed much over the past month, traders have reduced their bets on further hikes by the end of this year. They now see a total tightening of 75 basis points by the end of 2023, down about 15 basis points since April 1.
Amid the surge in breakevens, demand for inflation-protected funds picked up. Investors have invested more than $ 30 billion this year, according to data from EPFR Global.
Breakevens have long warned that they cannot be taken at face value due to the illiquidity of TIPS and the risk premium that investors demand due to the uncertainty on the path of the market. inflation – both of which lead to higher rates than would otherwise be. the case.
Fed officials developed models to account for these variables, and Pimco followed theirs. His conclusion, in a nutshell, is that inflation expectations are even further below the Fed’s 2% target than officials assume. This means traders may have to retreat close to zero on the Fed’s take-off expectations.
“We’ve basically argued that inflation expectations are a bit below what the Fed sees them” after hitting around 1.75% in March, the most recent reading of Pimco’s model, Tiffany Wilding said, an economist.
Plus, she sees the recent rise in five-year and five-year breakevens, which eliminate short-term noise like oil price swings, in part due to the uncertainty surrounding the outlook for inflation – as opposed to to a simple acceleration of expectations. .
“Because we think the entry rates are on a more aggressive Fed trajectory than we think, we like shorter-dated nominal bonds and believe there is value there. She said.
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