By Karen Brettell
(Reuters) – U.S. inflation expectations have surged to the highest in a decade as the economy reopens from COVID-19-related shutdowns, putting investors at odds with the Federal Reserve which sees price pressures still far from its target.
Inflation expectations as measured by breakevens on Treasury Inflation-Protected Securities (TIPS) over the coming five years jumped to a 10-year high of 2.73% on Monday.
The jump comes at the same time that Fed policymakers talk down inflation expectations, saying near-term inflation will be transitory and that there are challenges in reaching their average target of 2% on an ongoing basis.
Prices of commodities, houses and other goods and services are jumping as the government increases fiscal spending while the Fed also maintains low rates and unprecedented bond purchases. As the economy reopens investors are also pondering whether the Fed will be too slow in reacting to price increases, or if the market has gotten ahead of itself in pricing them in.
“At a certain point if inflation is high enough for long enough it is not really transitory anymore and the market is picking up on that and there is a general sense we are waiting for the Fed to weigh in on that as well,” said Tom Simons, a money market economist at Jefferies in New York.
Analysts at the BlackRock Investment Institute said the divergence in views likely comes from markets pricing for faster growth longer than it is likely to be sustained.
“Investors may be over-extrapolating from near-term growth data amid the powerful economic restart,” they said in a report on Monday. “We view the Covid shock as more akin to a natural disaster followed by a rapid ‘restart’ –instead of a traditional business cycle recession followed by a ‘recovery.’ That implies the huge near-term growth spurt will be transitory.”
Data on Friday showed U.S. job growth unexpectedly slowed in April, which may support the Fed’s caution on the economy.
“I certainly think that the jobs report on Friday leaves quite a few of the FOMC members feeling more comfortable in their stance,” said Jonathan Cohn, an interest rate strategist at Credit Suisse in New York.
Data on Wednesday is expected to show that consumer prices rose by 3.6% over the year in April. But that comparison is from a very low level last year when COVID-19 spread in the United States, and does not necessarily reflect a longer-term trend.
DISTORTING EXPECTATIONS
Fed Chairman Jerome Powell last month said a transitory rise in inflation does not meet the Fed’s standard for raising rates.
Plus, the Fed wants to keep real rates – Treasury yields after adjusting for expected inflation – down, which is also likely distorting expectations, said Jim Caron, portfolio manager and head of global macro strategies for the global fixed income team at Morgan Stanley Investment Management.
“One of the designs of the Fed right now is to push real rates lower as a form of stimulus,” he said. “It’s hard for me to look at the 10-year breakeven or the five-year breakeven and say this is an accurate reflection of where inflation is going to average over ten years’ time.”
Some technical factors may also be pushing breakeven rates beyond their fundamental value.
“Part of the story has to be at least how illiquid TIPS securities are. It’s not always a perfect reflection of inflation expectations,” said Michael Lorizio, senior fixed-income trader at Manulife Investment Management in Boston.
Credit Suisse’s Cohn also noted that the risk of higher inflation, even if it is not the prime expectation, is driving some of the move.
“Even if the expectation is you get elevated readings for a period of time but they revert back towards around 2% thereafter, I think it’s pretty clear that there is still considerable upside risks … and I think that risk is supporting the bid for inflation protection,” he said.
Analysts at JPMorgan said in a report on Friday they are neutral on TIPS as firmer inflation is already priced in to the debt.
The Fed is expected to shift its bond purchases in the coming months, which may marginally reduce purchases of TIPS and exert some downward pressure on breakeven rates.
(Reporting by Karen Brettell in New York; Additional reporting by Chuck Mikolajczak and Alden Bentley in New York; Editing by Matthew Lewis)
