Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services
- The U.S. equity market, represented by the S&P 500 index, was off 0.9% this week.
- June’s CPI inflation numbers came in hot, and the Fed is worried about inflation expectations becoming “unanchored”.
- There is little evidence that inflation expectations are out of control. The bond market has become sanguine on inflation, with breakeven inflation rates falling in recent weeks.
The Federal Reserve, and by extension most financial markets, have become fixated upon the Bureau of Labor Statistics’ monthly CPI inflation prints. While that data is backward-looking by nature, headline and core inflation numbers in June were miserably hot.
The Fed is also concerned about rising inflation expectations. Fed Chair Jerome Powell specifically cited rising inflation expectations in the consumer sentiment survey conducted by the University of Michigan in May as a concern and part of the justification for the Fed’s recent 0.75% increase in its target short-term interest rate.
Along with the debatable evidence that inflation expectations materialize into actual inflation, the Michigan survey of a few hundred people is of questionable value. As gasoline prices have steadily dropped over the past month, the Michigan survey’s June results released on Friday showed rapidly falling inflation expectations. As gas prices go, the survey shall follow. That said, most economists are terrible at forecasting inflation, so perhaps asking a bunch of households isn’t a bad approach.
Market participants put money on the line and take positions, so while the bond market is far from infallible, it is perhaps of more value to check in on what investors think. How is the bond market feeling about inflation?
One method of taking the market’s temperature is to measure the difference in yields between government bonds which pay a “real” interest rate plus an inflation adjustment versus bonds which pay a nominal interest rate. The difference between the nominal and the inflation-adjusted bond yields is referred to as the “breakeven” inflation rate, or the inflation rate above which it would be better to hold inflation-adjusted bonds versus regular old nominal bonds.
One-year and five-year breakeven inflation rates have been cratering recently. The bond market apparently does not believe inflation over the next few years will be a lingering issue. Relatedly, long-term interest rates have been falling and the yield curve is inverted. At the time of writing, two-year treasury notes yield more than ten-year or even thirty-year bonds.
Source: Bloomberg, July 2022
The Fed must be cheered by these charts, although it will continue to talk tough and raise rates until the monthly CPI inflation prints moderate and expectations for future inflation are well-anchored (however it chooses to define or measure that).
The Fed must also be contemplating that while its upcoming interest rate hike decision in July is of huge importance, other decisions, such as Vladimir Putin’s decision to turn natural gas back on for Germany or Xi Jinping’s decision on COVID lockdowns, could have much larger impacts upon global inflationary pressures. It is a tough spot for Mr. Powell and his brethren on the rate setting Federal Open Market Committee.
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