Market's view of transitory inflation may be premature
Ritchie Tuazon
Fixed Income Portfolio Manager
Tom Hollenberg
Fixed Income Portfolio Manager

We have seen an interesting paradox in the markets over the last couple of months: 10-year U.S. Treasury yields and breakeven rates on 10-year maturity TIPS (Treasury Inflation-Protected Securities) have moved lower even as inflation has moved meaningfully higher.

Headline inflation has surprised to the upside over the last two months, rising 0.8% month over month in April and 0.6% in May ― among the two biggest monthly increases since 2009. And April’s 0.9% month-over-month increase in the core Consumer Price Index (CPI), which strips out volatile food and energy components, was the highest in nearly 40 years.

Consumer price inflation surges

Line chart displays how the Consumer Price Index has changed from a year earlier and two years earlier on a monthly basis from 2000 through May 2021. It also shows when U.S. recessions occurred during that period. The chart shows that the index rose sharply in the final two months of the period, reaching a level last seen prior to the global financial crisis.

Sources: U.S. Bureau of Labor Statistics, Refinitiv Datastream. As of May 31, 2021.

Despite these upside surprises, Treasury yields and TIPS breakevens have moved lower. Since mid-May, when the first set of strong CPI data was released, 10-year Treasury yields have dropped from 1.69% to 1.50% and 10-year inflation breakevens have declined by 24 basis points. (The TIPS breakeven rate is the difference between the yields of Treasuries and TIPS of the same maturity.)

Two expectations likely helped drive this move: first, that elevated inflation readings are likely to be transitory; and second, that the Fed would be more likely to change its policy stance if inflation started running too hot. We question both assumptions.

Inflation in range of the Fed’s goal

The Federal Reserve’s June 16 meeting brought inflation concerns to the forefront as it made what some market participants saw as a “hawkish pivot” to a more aggressive timeline for tighter monetary policy. Fed chair Jerome Powell acknowledged these concerns in the June meeting press conference, saying longer-term inflation expectations have risen to a range consistent with the Fed’s long-run goal of 2%.

Powell also asserted that while factors driving higher inflation readings are likely to be temporary, they could push inflation even higher and remain persistent for some time. Importantly, he mentioned several times during the press conference that the Federal Open Market Committee (FOMC) “wouldn’t hesitate” to use its monetary policy tools should inflation or inflation expectations move higher — meaning potentially a faster end to policy accommodation.

The median FOMC participant has now penciled in two rate hikes by the end of 2023, up from zero in March. In addition, seven out of 18 members project a move in 2022, up from four.

Fed projections of higher rates

Chart displays the median Federal Reserve projection and market expectations for the lower bound of the federal funds rate target range in December of 2021, 2022 and 2023. It shows that the median Fed projection is for the rate to remain at zero in 2021 and 2022, before rising to 0.5% in 2023. The market expection is shown as 0% in 2021, 0.20% in 2022 and 0.70% in 2023. The chart also shows our interest rates team’s view of when the Fed will take four actions prior to a rate increase. It shows that the team believes the Fed will signal a taper of its asset purchases in the third quarter of 2021, begin tapering during the fourth quarter of 2021 or first quarter of 2022, end tapering sometime from the third quarter of 2022 to the first quarter of 2023 and signal a rate hike sometime from the fourth quarter of 2022 to the second quarter of 2023.

Sources: Capital Group, Bloomberg, Federal Reserve. Expectations reflect the lower bound of the fed funds target range. As of June 16, 2021.

The door is now open for the Fed to move toward tapering its asset purchase program, with an announcement possible as soon as the September FOMC meeting if inflation and employment data surprise to the upside.

Investors digested the message from the June meeting as a hawkish signal, resulting in a meaningful rise in short-term Treasury yields, a fall in longer-term yields, and a cheapening in the pricing of inflation expectations via TIPS.

Rate hikes are unlikely in the near term

Our view in the interest rates team is that, even accounting for this more aggressive scenario, rate hikes are still at least a year away. The Fed will likely fully implement its asset reduction program before lifting rates, following the playbook from the aftermath of the global financial crisis. Fed officials have made it clear that this is their preferred sequence for removing policy accommodation. Powell also made it a point to say that the policy discussions beginning within the FOMC were related to asset purchases, not rate hikes.

We think that the exodus from reflation trades and the pricing of more imminent rate hikes may be premature for a few reasons:

  • First, the Fed is still adding tremendous amounts of liquidity and tapering hasn’t even begun;
  • Second, we’re seeing meaningfully higher inflation than in the past and the risks are skewed toward persistently high readings in the coming months or quarters;
  • Third, rate hikes, while pulled forward, are likely at least 12 to 18 months away.

The Fed will need to adjust its asset purchases first before considering rate hikes, as Powell has stated many times in the past and reiterated on June 16. TIPS inflation expectations have more room to run in an environment where the Fed is likely to continue to add liquidity to the system for some time, as well as the potential for more upside surprises in the CPI.

5% annual inflation is possible

When we look at the underlying components of CPI, we think the upside risk to inflation exceeds the downside of what is priced in. Given low starting points and monthly base effects, it won’t take much to see very high year-over-year core inflation rates in the next 12 months. Even in a benign scenario, where the monthly increase in CPI softens to the pre-pandemic trend of around 0.15% month over month, annual core inflation will likely stay above 3% until late spring 2022.

In the more likely scenario where inflation pressures abate more gradually in the coming months, it could translate into an annual core inflation rate as high as 5% into next year — readings we haven’t seen since the early 1990s.

Select goods categories such as used cars and trucks, furniture and electronics are likely to continue experiencing higher prices due to ongoing supply-demand mismatches. As a result, goods inflation may continue to feed into the core CPI.

We have also been surprised by the quick rebound in rent and owners’ equivalent rent. It has accelerated back to the pre-pandemic trend, and based on the rebounding labor market, there could be further increases. We could also see broader inflationary pressures in services as the economy reopens further this summer and fall. Finally, the effects of extraordinary monetary and fiscal policy are still working through the system and are likely to contribute to any upward inflationary impulse.

Owners’ equivalent rent marches higher

Line chart displays month-over-month percentage changes in owners’ equivalent rent from 2009 through May 2021, along with a 3-month moving average. Owners’ equivalent rent increased throughout the period, except for several months in late 2009 and early 2010 amid the global financial crisis. The largest month-over-month increase of 0.36% occurred in September 2016. At its low point during the COVID-19 pandemic, it rose just 0.05% in November 2020 — the smallest increase since September 2010. It subsequently rebounded sharply, reaching a 0.31% increase in May 2021 — the largest month-over-month gain since June 2019.

Source: Bloomberg. As of May 31, 2021.

Portfolio positioning

We continue to invest in TIPS where appropriate and prefer investing in the front end of the yield curve versus the intermediate- and long-term maturities. We think short-term Treasuries with maturities of two years or less are attractive on the view that any Fed hike is unlikely before the end of 2022. On the other hand, intermediate five-year to 10-year Treasury yields should rise on inflation concerns.

Given that the slope of the five-year vs. 30-year Treasury yield curve flattened by 20 basis points in the week following the June Fed meeting, and the long bond yield has fallen by about 10 basis points, we also favor an underweight position in 30-year Treasuries. We have an overweight allocation to TIPS and especially favor five-year maturities, given our view that inflation could continue to surprise to the upside. 

Ritchie Tuazon is a fixed income portfolio manager with 23 years of industry experience (as of 12/31/23 ). He holds an MBA from MIT, a master's in public administration from Harvard and a bachelor's from the University of California, Berkeley.

Tom Hollenberg is a fixed income portfolio manager with 18 years of industry experience (as of 12/31/2023). As a fixed income investment analyst, he covers interest rates and options. He holds an MBA in finance from MIT and a bachelor's from Boston College.

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