Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, April 11, 2023
The Federal Reserve (Fed) has raised short-term interest rates at the most aggressive pace since the 1980s in an effort to bring down the highest inflationary pressures in more than 40 years. Certainly, the main motivation behind these aggressive rate hikes is to realign the supply/demand imbalances that create inflationary pressures. But, the Fed is also trying to ensure that inflation expectations don’t become problematic as well. Inflation expectations are simply the rate at which consumers and/or businesses expect prices to rise in the future. They matter because actual inflation depends, in part, on what consumers expect it to be. If consumers expect prices to continue to move higher, then they will likely change behaviors and inflation then becomes a self-fulfilling problem. There are three primary ways to track inflation expectations: surveys of consumers and businesses, economists’ forecasts, and market-implied inflation-related instruments.
And as seen below, market-implied inflation expectations, or what the bond market thinks inflation will average over time, have remained, more or less, in a normal range for the last six months and are seemingly well anchored. After spiking earlier last year, market-implied inflation expectations have fallen back to levels seen earlier in the last decade. Moreover, markets expect inflation to average 2.2% over the five year period, beginning five years from now (2028-2032), which is the Fed’s preferred way to measure long-term market-implied inflation expectations. So despite surprise production cuts from OPEC+ and bank stresses that many thought would prompt the Fed to abandon its inflation fight, markets continue to think the Fed will get inflation back to its 2% target.
And while we get additional CPI data on Wednesday that will likely show positive (albeit slow) progress, the bond market continues to believe the Fed will win its fight against inflation… one way or another. Markets are generally expecting one more rate hike in May but then rate cuts later this year. Expected rate cuts, still calm credit markets, and market-implied expectations drifting to 2% all suggest the Fed can win the fight. Can markets be wrong? Of course. And if investors think markets are too sanguine on the inflation fight, we would suggest a small allocation to TIPS strategies as a hedge.
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