Thoughts on US breakeven inflation rates: a new Fed stance and trade concerns

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In considering what drives breakeven inflation (BEI) rates, mostly the gap between the yield on 10-year US Treasury inflation-protected securities (TIPS) and that on regular 10-year Treasury notes which acts as a measure of expected inflation, our approach involves the analysis of their components, namely

(i) expected inflation

(ii) inflation risk premiums

(iii) liquidity premiums.

Analysing the components of breakeven inflation rates

In terms of expected inflation, our view is that US core inflation should slowly recover as transitory factors, such as the collapse in cell phone prices in March 2017, fall out of the 12-month comparison, while the inflationary effects from last year’s hurricanes will likely support categories such as shelter and vehicle prices. Commodity prices should also be under upward pressure from strong global economic growth and reduced energy inventories.

At the same time, however, a relatively flat Phillips curve will likely prevent wages from moving sharply higher. We believe the recent drop in medical cost inflation bear watching given the longer-term perspective of structural increases. We thus envisage a markedly slow pace of recovery for core inflation over the next two years. All this supports spot BEI rates, particularly of the shorter-maturity bonds.

Inflation risk premiums are driven by the swings in investor risk aversion relating to inflation. With US President Trump signalling significantly higher borrowing and spending, despite the economy already being close to full employment, and also threatening to start trade wars, there has been considerable interest in Treasury inflation-protected securities (TIPS) as investors look to hedge inflation risks. Inflows into TIPS and the strength of petrol prices have certainly supported BEI rates, although inflows do appear to have slowed in recent weeks.

Exhibit 1a: 10-year breakeven inflation rate (in %)

10-year breakeven inflation rate (in %)

Source: Federal Reserve Bank of St. Louis, as of 18/04/2018

Exhibit 1b: US headline CPI (%) and CPI medical care (index)

US headline CPI and CPI medical care

Source: Federal Reserve Bank of St. Louis, as of 18/04/2018

A more inflation-tolerant monetary stance by the Fed?

In considering the inflation risk premium, we need to assess any possible developments in the central bank’s reaction function. One upside risk for BEI valuations is the US Federal Reserve’s monetary policy framework becoming more tolerant with regards to inflation.

Indeed, some Federal Open Market Committee participants, as well as former Chairman Bernanke, have in recent months discussed whether the FOMC should, in extreme circumstances, pre-emptively commit to price-level targeting to more forcefully deliver on the Fed’s price stability objective.

San Francisco Fed President Williams, who was recently chosen to take over the New York Fed and the role of FOMC vice-chair, has supported this idea. As Chair Powell settles into his role, we believe it is highly likely that a review of the monetary policy framework will be announced in due course.

We should be cautious not to over-interpret these preliminary discussions. After all, we have been led astray before: former Fed Chair Yellen talked of tolerating ‘inflation overshoots’ and insisted on the ‘symmetry’ of the inflation target, only to see the FOMC raise the policy rate.

Raising the current target for personal consumption expenditures (PCE) inflation from 2.0% to 2.5% or 3.0%, or adopting a price-path targeting framework, would necessarily imply a much looser monetary policy stance. This might lift risk appetite and exacerbate financial stability risks.

From a positioning perspective, it could invite investors to establish very large TIPS duration and overweight BEI positions. However, at this juncture, we think this is a largely academic discussion focused on developing policy options for dealing with the next recession, and not a theme with immediate market implications.

Growing concerns over US trade policy

In mid-February 2018, as 10-year Treasury yields touched 2.96%, we had expected 10-year BEI rates to rise from 2.15% to 2.25% if 10-year nominal T-note yields breached 3.00% (given the fiscal stimulus news and the likely implication for Treasury bond issuance). However, growing international trade tensions and the passing of positive inflation accretion[1] have kept BEI yields from rising beyond 2.17%.

Exhibit 2: Net BEI positioning vs. 10-year BEI level

Net breakeven inflation positioning vs. 10-year breakeven inflation level

Source: Bloomberg, as of 09/04/2018

Our growing concerns over trade policy mean that we have recently turned our BEI overweight into a real yield overweight by closing our short position in Treasury futures, resulting in an almost flat net BEI exposure. With investors reportedly long TIPS, and with positive carry likely ending by June, we expect it to be difficult for BEI to outperform, unless upside core inflation surprises recommence and risk appetite recovers. We are concerned that, should 10-year BEI rates spend a number of trading sessions below 2.00%, we could see investors with ‘weaker hands’ being stopped out and forced to execute stop-loss sell orders.

[1] “Many inflation measures adjust for seasonality. So given the uptick in spending around the end-of-the-year holidays, you can expect more volatility in the pricing of these instruments as inflation measures compensate for this spending. In the United States, this leads to a somewhat predictable pattern of TIPS breakevens rising early in the year before declining again toward the end of the year.” Global Inflation-Linked Bonds: A Primer, by Jason Voss, CFA,

Other posts by Cedric Scholtes

Cedric Scholtes

Co-Head Inflation, Rates Committee Chair

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