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US inflation expectations hit 18-month high on vaccine hopes

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A measure showing financial market expectations for future US inflation has risen to its highest level in 18 months, as investors anticipate a robust economic revival in short order given recent vaccine breakthroughs.

The 10-year “break-even” rate, which is derived from prices of US inflation-protected government securities, hit 1.83 per cent on Tuesday, higher than at any point since May last year.

Meanwhile, a swap rate that measures expectations for the average level of inflation over five years, five years from now, has jumped to 2.25 per cent — above the 2 per cent inflation target that the US Federal Reserve has for years persistently failed to achieve.

That swap rate reached a record low of 1.2 per cent during the depths of the coronavirus-induced financial panic in March, before the Fed slashed US interest rates to zero and began pumping trillions of dollars into the financial system.

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“People need to be aware that once the nightmare is over you’ll see whole economies reopening at once, but there will still be all this liquidity floating around,” said Ludovic Colin, a bond portfolio manager at Vontobel Asset Management.

“We are going to have a sugar rush next spring, and we have to anticipate more inflation.”

With multiple vaccines showing positive results, investors have looked past the present surge in coronavirus cases globally and the reimposition of lockdown measures to stop the pandemic’s spread. They have instead shifted their attention to the potential rebound in growth that will pave a path to higher inflation.

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The Fed revised its inflation-targeting policy this year to embrace faster consumer price increases, further helping to bolster fund managers’ expectations. The central bank now says it will allow future inflation to run above the 2 per cent target to make up for earlier undershoots.

“Given monetary policy, which is extremely accommodative and will remain so for quite some time, and the fact that they are fairly explicit that they will let inflation overshoot, there is definitely the potential for more inflation in the medium-term,” said David Leduc, chief investment officer of active fixed income at Mellon. 

Line chart of Core personal consumption expenditures price index (%) showing US inflation languishes below the Fed’s target

While 3 per cent inflation appears far-fetched, Mr Leduc added that it is possible for inflation to be “consistently” above the Fed’s 2 per cent target “for some period of time”. The core personal consumption expenditures price index, the central bank’s favourite inflation gauge, currently hovers at 1.4 per cent. It briefly crossed 2 per cent in 2018. 

Longer-dated US Treasuries sold off on Tuesday as inflation expectations rose. Inflation is a particular concern for bond investors, as over time it erodes the real value of the fixed interest payments the securities provide. The yield on the benchmark 10-year Treasury note rose almost 0.1 percentage points at one point on Tuesday, to 0.94 per cent. Just two months ago it traded below 0.7 per cent. 

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“You don’t need a massive uptick in inflation to really do some damage to fixed income portfolios,” added Mr Colin. “We are careful about not being exposed to long-term yields.”

Strategists have adjusted their 2021 forecasts accordingly, with many expecting the benchmark yield to eventually rise to around 1.25 per cent. 

Still, some investors harbour deep scepticism about the future path of inflation in light of the uncertainty surrounding the economic outlook and questions about whether the Fed has the tools to achieve its target.

“They have expressed a comfort with overshooting [their target], but they haven’t really prescribed how they will get there,” said Gene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle. 

Broader “scarring” of the economy at a time when policymakers have struggled to agree to another fiscal package is also likely to impede a more sustained increase in inflation, according to Liz Ann Sonders, chief investment strategist at Charles Schwab. 

“We have seen a rise in permanent job losses,” she said. “That suggests that unemployment will remain high enough that it is unlikely to generate an overheated economy for the medium-term.”

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