One interesting feature of the recent price action is that despite the high conviction among investors that central bankers will act – that is clearly evident in the price of safe assets – market-based expectations for long-term inflation such as the 5-year/5-year forward (5y5yf) breakeven have not budged. Instead, they remain marooned at rock-bottom levels.
- Breakevens often move in sympathy with risk assets, but not this time
- Market signals that inflation will not be consistent with policy targets in the future
In truth, the behaviour of breakeven inflation rates is a puzzle. Alongside the optimism over imminent policy action, the news on the conduct of monetary policy in the medium term has also been broadly positive.
The US Federal Reserve continues to make gradual progress towards a modest change in its framework that should deliver a higher inflation rate on average in the future. The risk of a hawkish appointment to replace Mario Draghi as ECB president did not ultimately materialise. Nor are measures of underlying inflationary pressure in Europe or the US obviously moving in the wrong direction. A pragmatist would have expected a bounce given the rally in risk assets because breakevens often move in sympathy with risk assets.
Exhibit 1: A conundrum – breakeven inflation rates, derived from valuations of 5-year/5-year forward swaps, in the US and eurozone reflect market expectations that inflation rates will be lower in the future despite the declared intentions of the US Federal Reserve and the ECB to pursue policies conducive to higher rates of inflation.
Exhibit 2: Changes in underlying measures of inflation show little sign of rising inflationary pressures in the US or the eurozone
The behaviour of breakevens presents something of a puzzle for policymakers too. Market prices suggest that the market is beyond questioning the credibility of the monetary policy framework and is outright challenging the idea that inflation will be consistent with policy targets in the future.
In years gone by, policymakers might have been prompted into more decisive action in an attempt to restore credibility. However, the lower breakevens go, the more central bankers may conclude that the signal-to-noise ratio in these market-based measures of inflation expectations is very low, and hence there is less need to act in response.
This article is an extract from BNP Paribas Asset Management’s fixed income outlook
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.