(Bloomberg) — The bond market’s outlook on inflation is a key component for Federal Reserve policymakers in determining interest-rate policy. And what traders are signaling now is potentially problematic.
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So says Benson Durham, head of global asset allocation at Piper Sandler and former Fed economist. He points to his adjusted measure of long-term inflation expectations, which has ticked higher in recent months to exceed the Fed’s target of 2% — a sign traders see price pressures continuing into the future.
The risk for central bankers is that these expectations fuel actual inflation — and so, should they continue to bubble up, that could prompt a response in the form of a Fed rate hike, Durham says.
“Unachored long-run inflation expectations would prompt another Fed hike like nothing else,” Durham said in an interview. “We’re not there yet, but our eyebrows are raised.”
Already this year, hot inflation data and a persistently strong labor market have prompted Wall Street forecasters and investors to drastically scale back their expectations for rate cuts this year. Some now even speculate that the central bank’s next move could be a notch higher in rates, something Fed Bank of New York President John Williams signaled Thursday is possible should conditions warrant.
An auction Thursday of new five-year TIPS drew ample demand, proof of investor appetite demand for bonds that compensate for the risk of inflation.
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Particularly troubling to Durham is the rise in long run market-based measures of future inflation expectations, specifically the so-called five-year, five-year forward breakeven. The gauge — derived from Treasury Inflation-Protected Securities and traditional government debt — measures projections for average annual consumer price increases for the half decade beginning in five years.
The Fed itself has its own measure of the rate that it’s used to help guide policy for years, and it has moved upward this year. Durham and Piper Sandler’s Melissa Turner detailed in a note on Wednesday how their adjusted models for the gauge get a cleaner read of pure long-run forward inflation expectations by stripping out other factors affecting Treasury yields. These include liquidity as well as term premium — generally described as the extra compensation investors demand to own longer-term debt instead of rolling over shorter-term securities as they mature.
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“Estimates across models at the five-year horizon, relative to the Fed’s mandate, are not unmoored but are nonetheless greater than the long-run target,” said Durham, who during his tenure at the Fed helped the central bank create an options-based model deriving the market’s range of trajectories for the funds rate. “What really would get the Fed’s goat would be if people didn’t think they were going to hit their long-run inflation goal.”
Treasury term premium for its part has moved higher this year also. The term premium on 10-year securities moved above zero this week for the first time since November.
A more hawkish outlook for the Fed’s policy plans this year has upended hope for now that a popular wager on a steepening yield-curve — when short-term rates fall below those on longer-term debt — will pay off. As of Thursday, US two-year Treasuries yielded about 35 basis more than than 10-year US notes, compared with just under 16 basis points in January. Durham sees this trend continuing if long-run inflation expectations continue to increase.
“If I was to pick one indicator of whether the Fed was going to hike or to cut, these long-run inflation expectations would be at the top of the list,” said Durham. “Fed officials have said over and over again that their target is 2% and they are committed to that. And the more they get the sense that investors don’t think they are going to get there then the more they will feel they need to demonstrate that they mean business.”
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