Now that I have your attention, no, Fed Chairman Powell has not indicated any signs of a pullback in easing policy. In addition, Chairman Powell last week reiterated that the Fed would keep rates where they are and doesn’t see substantial risk of heightened inflation pressures in the current environment. However, in light of all that, long-term treasury yields have continued their sharp upward shift. Remember, bond yields rise when prices fall. And when a bond’s value declines, it’s typically because of dwindling demand for that asset. Usually when investors leave Treasuries, we see a rush for riskier assets (like stocks). Last week we did not see that. In fact, broad markets all sold off with the tech-heavy Nasdaq leading the fall. Much of the flows came out of high-growth companies to more cyclical-oriented stocks. So, what’s happening?
Yields on long-term Treasuries are not rising because of expectations that the Fed is reducing the size of its balance sheet (which is what caused the 2013 Taper Tantrum). The rise in yields can largely be attributed to increasing inflation expectations. And the most common way to measure inflation expectations for market participants is to look at Treasury inflation-protected securities, otherwise known as TIPS. The yield differential between an ordinary Treasury and its equivalent-maturity TIPS will tell you where investors think inflation will be at a specified time frame. This is what’s known as the breakeven rate. If the breakeven rate is positive, investors are expecting inflation to rise in the future. Investors purchase TIPS with the expectation of inflation being higher in the future. If they’re correct, they’re rewarded for it with an upwardly adjusted principal amount paid back to them at maturity. But I’ll leave the TIPS minutiae for another market update.
Anyways, lets go back to the breakeven rate and why it’s relevant to last week’s events. On the surface level, inflation expectations have continued to rise, seen with the 5-year breakeven rate currently sitting around 2.4% – the highest level since May 2011. But something strange is afoot. When taking a closer look, shorter-term breakeven rates are higher than longer-term ones. This is what’s known as an inversion of the breakeven curve. The image below shows the 5-year breakeven rate at 2.4% (trending upward), while the following 5 years show rates under 2% (trending downward). Investors are essentially expecting inflation to run up in the short term due to highly accommodative monetary and fiscal policy, and then a return to normal in the longer term.
While these numbers do provide us useful insight into the market’s inflation estimates, it’s important to remember that these are just that – estimates. And you know how well the markets do with exact, numerical predictions. In fact, the Bureau of Labor Statistics (BLS) ran a study in 2019 to compare expected inflation versus actual inflation from 2003 to 2018 showing the “accuracy” of these predictions. The chart below shows the standard deviation (y-axis) between expectations versus actual CPI rates based on matching maturity horizons (x-axis). Obviously, since the study was run for 15 years, the lower maturity horizons would have more observations than the longer maturity horizons. For example, the 6-month maturity horizon had 175 observations, while the 15-year maturity horizon only had 1 observation. Since a larger sample size paints a more accurate picture, the lower maturity horizons are probably the colors we’ll want to use on our canvas. Taking a look at the chart below, we can see that the lower maturity horizons have higher deviations between actuals and estimates for inflation.
My point isn’t to show the flaws in using market metrics to predict economic conditions, but to emphasize not to take everything at face value. It’s important to do your own research so you can make your own conclusions. That’s why we don’t make trades on headlines and stick to our process, especially in unpredictable economic climates. As always, please don’t hesitate to reach out to your financial advisor with any questions you might have.
Stay safe everyone!
– Matt Kawashima