Good news, everyone. We did it!
From Deutsche Bank this morning, with our emphasis:
The USD break-even market is pricing that US inflation will be back to target within three years. Assuming a 50bp PCE/CPI wedge, 2y1y break-evens are back in line with the 2% Fed target. This is happening while the market is pricing peak Fed funds just at 3.4%. This is just above the lower end of our estimated terminal rate range of 3.25-4.25%. While such outcome is plausible, the risks remain biased towards the Fed ultimately hiking more than currently priced in. However, given the bullish rate seasonals we maintain low risk for now.
The straightforward argument here is that the bond market is signalling the Federal Reserve will succeed in getting inflation back to 2 per cent. The implied argument is that the Fed won’t have to raise rates too much higher to do so; at 1.75 per cent, the US policy rate is now more than halfway to its market-forecast peak of 3.4 per cent.
Break-even rates are supposed to be the evidence for this. Many of our readers already know that break-evens are the inflation rate where Treasury Inflation-Protected Securities (or TIPS, the US version of linkers) are just as attractive as nominal Treasuries, so academics and commentators often use them as a real-time measure of the market’s inflation expectations. Some of our readers already know why decomposing rates can be a silly exercise.
The Deutsche Bank note says markets are predicting inflation will recede to 2 per cent between mid-2024 and mid-2025 — based on 2-year 1-year forward break-even inflation rates.
If the chart gives you a headache, there is good reason. First, short-dated TIPS aren’t especially liquid, as the US doesn’t issue new TIPS with maturities shorter than 5 years. And instead of using break-even rates for the illiquid short-dated TIPS, Deutsche Bank uses forward break-even rates in the market for illiquid short-dated TIPS.
To make their case, the strategists are also required to subtract half of a percentage point from that break-even rate. TIPS are priced on the consumer price index, while the Fed targets a broader measure, the price index for personal consumption expenditures, which do typically run below the CPI.
As Bespoke’s George Pearkes observed many years ago, it is tricky to draw conclusions from forward rates.
And nearly everyone has observed that break-evens are highly correlated with oil prices in ways that undermine their reliability as an indicator of future inflation.
Energy and commodities melted down earlier this week, and West Texas Intermediate crude futures are still down 4% for the week even after a Thursday rebound. Technical factors seem to be driving a lot of the move.
This doesn’t necessarily mean that the Deutsche Bank strategists’ conclusions are wrong. It is possible that the Fed won’t have to raise rates much more before inflation decelerates.
But perhaps instead of looking at a forward rate in an illiquid section of an already-illiquid yield curve that is very closely tied to oil prices, it could be more sensible to just look at oil prices instead.
Source: Economy - ft.com
