The Federal Reserve wants inflation to soar, but a sudden and recent surge in U.S. government bond yields and inflation expectations shows some investors fear they are getting burned.
Inflation is expected to rise over the next few months as lows last spring reverse year-over-year calculations and pent-up consumer demand likely rages on. But the biggest question facing bond markets is whether the rebound in inflation will hold up or be little more than a failure.
“The market is still trying to understand [this] Dominic Nolan, senior managing director of Pacific Asset Management, the asset management arm of Pacific Life Insurance Co., said in an interview. Pacific Asset Management has $ 18.5 billion under management through its affiliates and subsidiaries, according to its website.
The government bond market has seen volatile trading as hopes of a strong economic recovery grew, with benchmark 10-year Treasury yields rising above 1.5% on February 25 and again on February 4. March. The yield was trading above 1.6% at the start of March 5. following the publication of a stronger-than-expected employment report in the United States.
Right now, bond market moves reflect more of a brighter economic outlook that pushes interest rates away from the lowest level than inflation concerns. But bond market inflation expectations have soared in 2021 and “inflation fears are bothering investors,” wrote Tom Essaye, trader and founder of The Sevens Report, a financial research firm. Stock markets fell to record highs in part because of these concerns, with tech stocks hit the hardest as investors criticized their valuations in a period of rising interest rates.
The five-year breakeven inflation rate, a rough measure of the bond market’s view of inflation over the next five years, has closed the 3 of March at 2.45%, its highest level since July 2008. The 10-year breakeven inflation rate closed the 3 of March at 2.21%, its highest level since August 2014. But it’s well below the five-year breakeven point, suggesting investors see some of the short-term inflationary pressures ease later.
This would be consistent with the current view of the Fed, which sees a temporary explosion in inflation but does not expect it to continue.
“People would need to believe that larger price increases would be repeated year after year, and we think these deeply entrenched low inflation expectations are unlikely to suddenly change,” said the Fed chairman, Jerome Powell, at an event organized on March 4 by The Wall Street Journal, adding that the Fed “will be patient” in removing its low interest rate policies if inflation expectations remain stable.
If inflation expectations rise too quickly, Fed officials believe “they have the tools” to roll them back through the usual method of raising interest rates, said Rubeela Farooqi, chief US economist at High Frequency Economics, in an interview.
But the Fed has indicated it will look beyond any temporary increases in inflation and actually welcome warmer inflation after years of underperforming most of its 2% target. .
“It’s really too low inflation that they have a problem with,” Farooqi said.
The central bank made a historic change to its monetary policy framework in August 2020, largely to address this concern. It now explicitly aims for inflation to rise slightly above 2% for a period of time to roughly average the time it has been below the target. The Fed has also said it will keep its benchmark rate at effectively 0% until it sees a “widespread and inclusive” labor market recovery, with inflation reaching 2% and being on track for. exceed it moderately. The central bank also said it would continue to buy $ 120 billion in bonds each month until it sees “further substantial progress” on those targets.
The basic personal consumption expenditure price index, or basic PCE, which excludes food and energy prices and is the Fed’s preferred measure of inflation, rose 1.5% from year to year in january. Inflation plummeted in 2020 as spending on everything from hotel rooms to gasoline plummeted with limited demand during the pandemic.
Oxford Economics predicts that inflation will reach 2.35% from the fourth quarter of 2020 to the fourth quarter of 2021, but this inflation will slow down thereafter, increasing from just 1.98% from the fourth quarter of 2021 to the fourth quarter of 2022.
“While ‘hot’ inflation may seem ‘hot’ after a decade of inflation below 2% in the wake of the financial crisis, widespread overheating is not likely,” wrote Gregory Daco, chief US economist from Oxford Economics, in a March 2 memo. “We expect the Fed to examine transitional inflationary pressures and focus on achieving a ‘broad and inclusive’ labor market recovery before removing accommodations.”
Some analysts, however, believe the Fed may underestimate the rebound in inflation and may be forced to tighten policy faster than it expects.
Once the virus is under control, the US economy is “poised for a rebound” that will be much faster than the slow recovery from the 2007-09 financial crisis, according to Sonal Desai, chief investment officer at Franklin Templeton Fixed Income. The tax support has put households in much better shape this time around, with lots of unprecedented savings and “keen to get back to normal spending habits,” she wrote in a research note. The personal savings rate in the United States jumped 20.5% in January, from 7.6% a year earlier.
Supply shortages and the ongoing recovery are also pushing up the prices of a wide variety of commodities and products, such as petroleum, copper and semiconductors, Desai wrote.
Central bankers appear confident that inflation expectations will remain subdued and that they can control “the devil they know” with interest rate hikes that reduce inflation, Desai wrote. But assuming inflation expectations will stay pegged at around 2% “might be overly optimistic” as prices start to rise, Desai added.
Goldman Sachs predicts core PCE inflation to peak at 2.4% in April, compared to April 2020, when many lockdowns were in place. Goldman predicts inflation will end at 2% this year, but as Jan Hatzius, the investment bank’s chief economist, noted in a March 2 report, there could be a lot more room. for inflation to rise.
“How much could core inflation go up if mass vaccination triggers growing demand in virus-susceptible categories?” Hatzius asked.
But Nolan, of Pacific Asset Management, said longer-term disinflationary pressures were “considerably underestimated.” This includes the “unstoppable force” of technological advancements and automation, which the COVID-19 pandemic could fuel further as employers find new ways to replace workers. The United States and other developed countries still have an aging population, which makes their economies less vibrant, Nolan added.
Investors continue to understand how the Fed’s new inflation tolerance will play out, including the extent to which the Fed will allow inflation to rise above 2% before starting to reduce it.
“Balance is gravity versus duration,” said Peter Cecchini, CEO and founder of AlphaOmega Advisors, in an interview. “Would the Fed tolerate a quarter of 3% inflation? I think. Would it tolerate three quarters of 3% inflation? Maybe. A quarter of 5%? I doubt it.”