Short and intermediate-term inflation expectations, as measured by 2-year and 5-year breakeven inflation rates, reached their highest levels last week since 2005. Breakeven rates are the difference between inflation-linked bond yields and nominal bond yields of the same maturity; if actual inflation equaled the breakeven rate, an investor would be indifferent between holding an inflation-linked bond or a nominal bond. As shown in the LPL Chart of the Day, 2-year and 5-year breakevens have reached 4.3% and 3.3%, respectively. Longer term inflation expectations rose last week as well (10-year breakevens reached 2.72%), but did not surpass previous highs seen in November 2021.
The rise in “front end” or shorter-term inflation expectations are primarily due to two factors:
- Commodity price disruption. A sharp rise in oil prices (crude oil surpassing $120 a barrel) due to Russian sanctions and possible bans on importing Russian oil is pushing inflation expectations higher, but disruption in other Russian exports may impact more than just energy prices. Russia is a major exporter of wheat and metals (platinum and palladium), and recent events suggest upside risk to food prices and metal dependent goods, such as vehicles.
- Monetary policy. The Federal Reserve’s (Fed) monetary tightening expectations have declined given concerns over potential negative growth impacts from higher oil prices. The market’s expectations of an aggressive rate hike path forward have dropped meaningfully over the last month. At the start of February, there was a 30% chance of a 50 basis point (bps) rate hike this month (per CME Group); however, today that percentage has dropped to zero as market participants expect a 25 bps hike. A less hawkish Fed may result in higher inflationary pressures for longer.
During Chair Powell’s testimony in front of the House Financial Services Committee last week, Powell noted that the impact of Russia’s invasion of Ukraine is highly uncertain, and the Fed will “proceed carefully.” While recent geopolitical events have driven short-term inflation worries higher, Powell reassured Congress last week that the Fed will get inflation “back under control.” Powell also reiterated the Fed’s plan to raise rates this month given the health of the U.S. economy and a strong domestic labor market.
These potential short-term inflationary pressures and flight to safety dynamics have fueled strong relative returns in the Treasury Inflation Protected Securities (TIPS) market over the last month, with the Bloomberg U.S. TIPS index returning over 3%. The Russia / Ukraine conflict adds a layer of complexity to inflation forecasting and expectations. However, we continue to believe long-term inflation will be limited by structural forces such as technology and demographic trends.
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All index and market data from FactSet and MarketWatch.
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