Stocks and corporate bonds aren’t the only markets that have been looking past the pandemic—the bond market’s gauge of inflation expectations has strengthened back to pre-Covid levels as well.
The gap between yields on Treasuries and comparable Treasury inflation-protected securities, or TIPS, has been widening. That metric is known as the “break-even inflation rate,” because at that inflation rate the two securities’ returns are roughly the same. Put simply, the break-even rate is the compensation that bond investors demand for the risk of inflation over a certain period.
For example, the 10-year break-even inflation rate is about 1.87%, according to Bloomberg data. So holding a 10-year TIPS and a 10-year Treasury note to maturity should be equally attractive—starting today—if inflation averages 1.87% each year over the next decade, according to Bloomberg data. That is the highest that figure has been since 2019.
In fact, most tenors of break-even rates are the highest they have been since 2019. That matters because rising inflation expectations have been a major factor pushing long-term Treasury yields higher, and Treasury yields are a widely used benchmark for borrowing costs across the economy.
But rather than a reason for concern, or for the Federal Reserve to raise short-term rates, strategists say that the inflation-expectation rebound simply reflects the continued global economic recovery from the coronavirus pandemic, and improved prospects of stimulus from Washington.
First, only the 30-year break-even inflation rate is nearing 2%, which is generally seen as the Fed’s target. The 10-year remains below 1.9%, and the five-year rate is just 1.78%.
And using the 2% break-even rate as a trigger for the Fed to act is likely not warranted in the first place. TIPS are pegged to the Consumer Price Index, or CPI, while the Fed uses the Bureau of Economic Analysis’s personal consumption expenditures figure, or PCE, as its gauge.
What’s more, the Fed has announced a shift in its approach to inflation in recent months. It is pursuing a strategy of “average inflation targeting,” by which it will allow inflation to run above target to make up for times when it fell sharply below, as it did during the shutdowns earlier this year.
That will be important to remember next year when headline inflation figures rebound sharply from this year’s pandemic slump, Mark Cabana, BofA Securities strategist, said. Prices of oil, travel and other goods sank during the lockdowns and market panic at the start of the pandemic. So next spring, headline inflation will surge—but only compared with this year’s depressed levels.
“That pop in [the Consumer Price Index] is not going to be sustained,” Cabana said on a 2021 outlook call this week. And “the Fed will stress to the market that they’re really serious about letting the economy run really hot.”
Rising inflation expectations, and Treasury yields, have also come alongside a decline in the dollar since late October that has picked up in recent days. The ICE Dollar Index is down more than 1.2% this week, and 2.3% in the past three weeks.
The dollar’s decline should actually bode well for global trade and the economy, Wall Street strategists say.
“U.S. currency weakness is good news for global markets and the world economy. Trade will increase, financial conditions improve—risk on!,” Dario Perkins, global macro strategist with TS Lombard, wrote in a note on Thursday.
And when it comes to any negative economic effects from higher long-term Treasury yields and borrowing costs, the Fed has an option for that as well. It could buy more long-term Treasury notes and bonds. The board discussed how and when to do that at its November meeting.
Bank of America’s Cabana doesn’t think the Fed will boost its longer-maturity bond purchases at its meeting on Dec. 15 and 16. But it could happen next year, he said on the call. And instead of inflation, he emphasized the economic recovery as an important driver of the increase in long-term Treasury yields.
“We think the longer-run growth expectations are extraordinarily depressed right now,” he said.
Write to Alexandra Scaggs at [email protected]