Federal Reserve Chair Jerome Powell’s increasing focus on protecting the job market is encouraging a swath of bond traders putting bets on inflation rates to remain elevated.
“Powell essentially endorsed being long breakevens,” said Tim Magnusson at Garda Capital Partners, referring to a trading strategy that profits from inflation-linked securities outperforming regular Treasuries.
The Fed chief for the first time in the current cycle last week in his press briefing rammed home the point that a surprise increase in unemployment could prompt officials to lower interest rates. Central bank policymakers’ updated forecasts, released March 20, also featured a faster expected pace of inflation and growth for 2024 while retaining a projection for three rate cuts in the so-called dot-plot.
“I guess they are willing to tolerate a little more inflation than what we otherwise would have thought,” said Magnusson, the hedge fund’s chief investment officer.
Magnusson’s not alone in his take. Bank of America Corp. strategists, led by Mark Cabana, on Wednesday recommended bets on 30-year breakevens. “A Fed that is guiding to cut alongside easy financial conditions, stronger growth expectations and greater upside risk to inflation suggests higher inflation compensation.”
The breakeven market suggests that inflation expectations have been creeping higher. The five-year breakeven rate — which measures the difference between the yield on regular five-year notes versus their inflation-protected counterparts — is currently about 2.43% — well below the peak of around 3.76% in early 2022 - yet roughly 40 basis points up from the December low.
Swaps traders on Thursday slightly trimmed wagers that the Fed would cut rates as soon a June following Fed Governor Christopher Waller’s comments on Wednesday that there was no rush to lower interest rates. The contracts now show an implied probability of about 60% for a June rate reduction.
Waller in remarks Wednesday before the Economic Club of New York emphasized that recent economic data warranted delaying or reducing the number of cuts seen this year.
A further climb in breakeven rates could encourage bets on a steepening in the yield curve. Many investors have bet that longer-term Treasuries will underperform as the Fed cuts rates and inflation lingers above pre-Covid levels. That would see a restoration of the typical premium of 10-year over two-year Treasury yields.
Survey-based measures of inflation expectations, which Fed policymakers watch closely along with market-derived ones, also suggest a faster pace of consumer price rises than seen in the recent past. Consumers see an average pace of 2.9% over the next five to 10 years, the latest University of Michigan survey shows. That’s up from 2.2% before the pandemic.
Fed policymakers’ own new median projections show their preferred gauge, known as the PCE price index, running above their 2% target this year and next. They boosted their estimate for the core measure — which strips out volatile food and energy costs — for this year to 2.6% from 2.4% back in December.
Powell said last week that “the higher year-end number reflects the data we’ve seen so far this year,” including faster-than-expected price gains in January and February. “Nonetheless, we’re looking for data that confirm the kind of low readings that we had last year and give us a higher degree of confidence” inflation is moving sustainably toward 2%,” he said.
On Friday, the latest PCE price report is expected to show a core monthly increase of 0.3%, still inconsistent with the Fed’s target.
Jim Bianco, who runs his own macro research firm, said the Fed runs a risk by moving to cut rates while inflation is still high.
“If they are not careful, they could cut rates and if the bond market is thinking they are not serious about inflation, we could wind up with higher yields, not lower yields,” Bianco said on Bloomberg Television recently.
Powell’s message last week about balancing the risk of inflation-fighting and safeguarding the labor market means it may take longer for inflation to fall toward 2%, according to Gang Hu, managing partner at Winshore Capital Partners.
“The Fed’s reaction function has changed,” said Hu. “The Fed is paying closer attention to the unemployment rate than inflation. It’s more likely for breakeven rates to go up than go down.”
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