High suggestions may come from the inflation markets: Mike Dolan
(The author is the Editor-in-Chief, Finance and Markets for Reuters News. All views expressed here are his own.)
LONDON, Feb. 6 / PRNewswire / – At a critical juncture in the return of the economy to normal, the inflation compass could become jumbled.
Global markets now depend on whether the post-pandemic economic recovery and massive financial support will sustainably raise inflation over time or possibly drive price hikes higher.
One of the few ways to gauge this is to look at key market and survey-based expectations.
These likely define your view of the speed with which central banks normalize lows. when or whether equity and bond markets that rely on this support are correct; or even the path of the world’s most important reserve currency.
However, there is good reason to suspect that signals from U.S. Treasury Department inflation-protected securities (TIPS), widely used by policy makers and asset managers, are skewed and too high, even as they draw some of the largest investment inflows in 6 months.
So-called “breakevens”, which reflect what investors see as the likely average inflation rates over 5, 10 and 30 years, are simply the gap between nominal bond yields and those on inflation-hedged bonds.
In theory, fear of rising inflation increases demand for inflation-linked bonds and lowers the TIPS rate of return – the “real” or inflation-adjusted rate of return – relative to nominal returns and to the point where the market clears in light of future inflation.
In addition to household surveys and various swap markets, the central banks then see how credible their inflation targets are.
Right now, they’re critical to determining if wild monthly price swings related to lockdowns and reopenings are nothing more than noise from base effects and bottlenecks.
Nonetheless, it is suspected that the limited supply of these bonds and the fact that the Federal Reserve is buying up a growing stake as part of its monetary policy is distorting its signal and overrating rather than underestimating market fears.
JPMorgan’s bond team suggests that the Fed’s “footprint” has become “oversized” in TIPS, largely because auction sizes have increased less than nominal bonds. Fed purchases more than fully absorbed net TIPS emissions last year and will likely continue to do so for the remainder of 2021, it said.
The Fed’s share of the TIPS market rose from less than 10% to 24% before the pandemic and primary trader positions fell even more than regular bonds.
At the very least, it would prevent the Fed from buying more TIPS if it wanted to adjust its $ 120 billion monthly commitment from mortgage bonds to government bonds, JPM said.
“Increasing the pace of monthly purchases in the product could create undue distortion that would make it more difficult to spot price signals from TIPS,” it said.
Some think that’s already happening. Oxford Economics’ John Canavan believes the bias is already “exaggerating” breakeven inflation rates.
So are 2.65% and 2.46% breakevens for 5 and 10 year TIPS really overcooked?
There is no shortage of private demand for these securities. Bank of America’s most recent weekly fund flow monitor shows the largest inflows into TIPS funds in 24 weeks.
But that demand on top of the Fed’s purchase has pushed real yields well below zero, hitting a record -1.9% on five-year TIPS.
Inflation-linked swap markets like the 5-year / 5-year forwards suggest lower interest rates of 2.40%.
Is the Fed distorting its own compass?
Perhaps knowing the offset is one of the reasons Fed officials are comfortable with expectations remaining “well anchored” while accepting rates above their core inflation target of 2% for a period is an integral part of their new strategy to average this goal over time.
The release of the Fed’s favored PCE core inflation measure on Friday is expected to hit 2.9% in April – still badly hit by pandemic bottlenecks.
As HSBC points out, the core PCE would have to average 3% for 12 months to pull a moving average of the past three years to 2.0% and even come close to satisfying the Fed’s new regime.
Surveys of expectations do not offer a crystal ball either.
The University of Michigan household surveys show that 1-year and 5-year expectations are above 4% and 3%, respectively, with 10-year highs. However, these have largely overstated the actual core PCE results over the past 25 years by a wide margin.
Private companies, who are price takers, setters, and collective bargaining agents, don’t seem much better.
A recent article by economists Bernardo Candia and Yuriy Gorodnichenko of the University of California, Berkeley and Olivier Coibion of the University of Texas examined their three-year-old quarterly survey of US firms for clues.
However, they found that this largely mirrored the household surveys, which continued to overestimate inflation, with large variances and disagreements, and frequent large changes in the assumptions made by companies.
Remarkably, less than a fifth of the polls’ executives even knew what the Fed’s inflation target was.
Economists conclude that corporate inflation expectations seem “anything but anchored”. However, they believe that one reason the “inattention” to monetary goals is how long inflation has not been a problem.
(by Mike Dolan, Twitter: @reutersMikeD. Charts by Stephen Culp, JPMorgan. Additional reporting by Karen Pierog. Editing by Alexander Smith)