What do investors think about US inflation?

If investors who worry about stagflation are correct, equities should be sinking. 

The US Treasury (and other governments) issues two types of bonds: ordinary bonds that promise that the principal will be fully repaid and Treasury Inflation Protected Securities (TIPS; in the United States) that promise that the principal will move in line with inflation. Because investors are protected from inflation, the yield on TIPS is a real (inflation-adjusted) yield. Ordinary bonds provide a yield that, theoretically includes both the real return and investor expectations of inflation. Mr. Ira Kalish, Chief Global Economist, Deloitte Touche Tohmatsu, said the difference between the yields on ordinary and TIPS bonds would be the investor expectation of inflation, also known as the breakeven rate. 

In recent months, breakeven rates for five- and 10-year bonds have been rising as investors became increasingly worried about the potential for longer-term inflation. Still, breakeven rates have remained relatively muted, far below the actual inflation we have lately seen and reasonably close to the Federal Reserve’s target of 2.0% inflation.

10-Year Breakeven Inflation Rate (T10YIE)

Mr. Ira Kalish said this likely reflected investor expectations that the current high inflation would turn out to be transitory. Indeed, the five-year breakeven rate has lately exceeded the 10-year breakeven rate, indicating that investors expect higher inflation in the short term than in the long term. This is consistent with the story that current inflation will be transitory. “For some time, I and other economists have argued that, if breakeven rates suddenly spike, then investors will have become worried and will have upwardly revised their expectations, possibly compelling central banks to tighten monetary policy faster than anticipated”, Mr. Ira Kalish stressed.

In the past two weeks, breakeven rates started to spike. That is, they increased sharply, suggesting that the market zeitgeist is shifting as business leaders increasingly bemoan the apparent persistence of inflation. The supply chain problems in the global economy increasingly appear difficult to undo and the continuing rise in oil prices is a source of distress. Indeed, oil prices are now at the highest level since 2014. From October 19 through 22, the 10-year breakeven increased from 2.54% to 2.64%—a jump of 10 basis points and hitting the highest since 2006. The five-year breakeven increased from 2.71% to 2.91%, a jump of 20 basis points and hitting the highest since 2005. 

Federal Reserve Chairman Powell was asked about this on October 22. Here is what he said: “The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation. Supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages. If we were to see a risk of inflation moving persistently higher, we would certainly use our tools.” He did not walk away from the transitory narrative. However, he appeared to suggest that the definition of transitory is a bit more prolonged than previously believed. He also attempted to reassure investors that the Fed is prepared to change course if things get out of hand. 

Meanwhile, two-year US bond yields have risen sharply recently. Mr. Ira Kalish said these yields would be a good proxy for investor expectations about short-term rates, which are controlled by central banks. Thus, a rise in the yield on short-term bonds suggests that investors expect the Federal Reserve to increase short-term rates sooner and by more than previously anticipated. In other words, investors evidently believe that the probability the Fed acts soon has increased, if only a little. Currently, the market is pricing in an increase in the Federal Funds rate late in 2022. 

Finally, US equity prices have rebounded to a record high. If those who worry about stagflation are correct, equities should be sinking. What is happening? Mr. Ira Kalish said there would be some things that investors should pay attention to. First, let’s define stagflation. Stagflation describes what happened in the 1970s when the economy was stagnant amidst unusually high inflation. Given that, historically, there has often (but not always) been an inverse relationship between growth and inflation (at least in the short term), stagflation is seen as perverse in that prices rise rapidly even amidst slow growth, and growth remains slow, even with significant inflationary pressure. That is not the case for now, at least not yet. The economy appears to be growing rapidly, with very strong consumer demand, something that is likely contributing to the current high inflation. Rising equity prices suggest that investors expect continued strong growth. Moreover, perhaps they recognize that inflation can often be good for corporate profitability as it reduces consumer sensitivity to price movements. 

At the same time, perhaps investors expect inflation to ultimately fade, thereby allowing for continued low borrowing costs amid healthy growth. Indeed, an index of the prices of industrial metals fell sharply last week, suggesting that prices had previously overshot, or that shortages are starting to abate. Either way, this is evidence in support of transitory inflation. Finally, investors might be pleased that the yield on TIPS, which is the real, or after-inflation yield, has been falling into deep negative territory. “That means that, after inflation, the cost of government borrowing is negative. That, in turn, is favorable for businesses that want to invest heavily”, Mr. Ira Kalish said.