We have seen an interesting paradox in the markets over the last couple of months: 10-year US Treasury yields and break-even rates on 10-year maturity TIPS (Treasury Inflation-Protected Securities) have moved lower even as inflation has moved meaningfully higher.

Headline inflation has surprised to the upside over the last two months, rising 0.8% month-over-month in April and 0.6% in May ― among the two biggest monthly increases since 2009. And April’s 0.9% month-over-month increase in the core Consumer Price Index (CPI), which strips out volatile food and energy components, was the highest in nearly 40 years.

Consumer price inflation surges¹

Despite these upside surprises, Treasury yields and TIPS breakevens have moved lower. Since mid-May, when the first set of strong CPI data was released, 10-year Treasury yields have dropped from 1.69% to 1.50% and 10-year inflation breakevens have declined by 24 basis points. (The TIPS breakeven rate is calculated as the difference between the yields of Treasuries and TIPS of the same maturity.)

Two expectations likely helped drive this move: first, that elevated inflation readings are likely to be transitory; and second, that the Fed would be more likely to change its policy stance if inflation started running too hot. We question both assumptions.

Inflation in range of the Fed’s goal

The Federal Reserve’s June 16 meeting brought inflation concerns to the forefront as it made what some market participants saw as a “hawkish pivot” to a more aggressive timeline for tighter monetary policy. Fed chair Jerome Powell acknowledged these concerns in the June meeting press conference, saying longer-term inflation expectations have risen to a range consistent with the Fed’s longer-run goal of 2%.

Powell also asserted that while factors driving higher inflation readings are likely to be temporary, they could push inflation even higher and remain persistent for some time. Importantly, he mentioned several times during the press conference that the Federal Open Market Committee (FOMC) “wouldn’t hesitate” to use its monetary policy tools should inflation or inflation expectations move higher — meaning potentially a faster end to policy accommodation.

The median FOMC participant has now pencilled in two rate hikes by the end of 2023, up from zero in March. In addition, seven out of 18 members project a move in 2022, up from four.

Fed projections of higher rates²

The door is now open for the Fed to move toward tapering its asset purchase program, with an announcement possible as soon as the September FOMC meeting if inflation and employment data surprise to the upside.

Investors digested the message from the June meeting as a hawkish signal, resulting in a meaningful rise in short-term Treasury yields, a fall in longer-term yields, and a cheapening in the pricing of inflation expectations via TIPS.

Rate hikes are unlikely in the near term

Our view in the interest rates team is that, even accounting for this more aggressive scenario, rate hikes are still at least a year away. The Fed will likely fully implement its asset reduction program before lifting rates, following the playbook from the aftermath of the global financial crisis. Fed officials have made it clear that this is their preferred sequence for removing policy accommodation. Powell also made it a point to say that the policy discussions beginning within the FOMC were related to asset purchases, not rate hikes.

 

1. Source: US Bureau of Labour Statistics, Refinitiv DataStream. As of 31 May 2021.

2. Sources: Capital Group, Bloomberg, Federal Reserve. Expectations reflect the lower bound of the Fed funds target range. As of 16 June 2021.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.

<