A closely watched bond market gauge of expected US inflation is rising back toward a nine-year high, signaling concern the Federal Reserve may continue to wrestle with elevated price pressures for years.
Ahead of the latest monthly consumer-price index data on Thursday, a key long-term measure of where the market sees inflation heading has risen to around 2.5%, just shy of the peak in April 2022, when it reached the highest since 2014.
The upward shift in the gauge — the so-called US five-year inflation breakeven that begins in 2028 — stands in contrast to broader speculation that the Fed’s steep interest-rate hikes are set to keep reining in the biggest consumer-price surge since the 1980s. The swaps market is pricing in that the central bank is likely done tightening monetary policy, with inflation expected to cool enough that it will be cutting rates next year.
“Inflation has come down because the Fed has acted aggressively — and yet there is a risk that underlying inflation expectations have shifted higher,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments.
“Markets have embedded in higher inflation expectations for the foreseeable future and also higher real rates,” he said. “Whether that’s correct, we will find out. But that’s what markets are saying.”
This week’s consumer-price index report is expected to show that it increased at a 3.3% annual pace in July, marking the first acceleration since June 2022, according to the median forecast of economists surveyed by Bloomberg. The core measure — which strips out volatile food and energy prices — is expected to ease slightly to 4.7%.
While down sharply since last year, the figures show the Fed still has some way to go before inflation is back at its 2% target. The bank’s preferred measure — the personal consumption expenditure index — rose at a 3% annual pace in June.
The latest rise in the five-year breakeven rate follows a selloff in the Treasury market that pushed up long-term yields faster than those on shorter-maturity securities. While some of that reflects concerns about the US’s downgrade from Fitch Ratings and a deluge of Treasury sales to cover the federal deficit, it also has been driven by speculation that the resilient economy will prevent inflation from sliding smoothly back to the central bank’s target.
“The issue for investors is can you make the case that the lion’s share of cooling inflation has occurred,” said Kevin Flanagan, head of fixed-income strategy at Wisdom Tree. “Is the best behind us in terms of inflation dropping sharply?”
George Goncalves, head of US macro strategy at MUFG, said the market’s inflation expectations are not high enough to show major worries yet.
But a push toward 2.75% or 3% in the long-run gauge, “would mean there’s more of a case to be concerned and that the market’s inflation psyche is shifting,” he said. “It would bring into question whether the Fed can maintain a 2% inflation target.”
He said concerns about the Fed’s ability to achieve its inflation goal — if sustained — would exert pressure on longer-date bonds, pushing up the yields faster than those on shorter-term securities.
“If long-term expectations break out toward 2.75% and the yield curve steepens further, that would suggest more worries about the inflation outlook,” said Goncalves.
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