Fed paddles, Bonds glide and Real rates still negative

Image: Frank Cone

Bond prices are a function of expectations for economic growth and inflation.

We all know that recently, growth expectations have been in decline. There are numerous PMI lead indicators and sentiment surveys that you can look at.

But what about inflation? It’s a hot topic and there are many schools of thought.

One way to estimate inflation expectations is to calculate a breakeven rate.

You do that by deducting the yield on treasury inflation protected securities (TIPS) from nominal treasuries of the same maturity. The differential represents expected inflation for the relevant time period.

In the charts below, I've used FRED data to plot the U.S. bond market's medium range inflation expectations (5 and 10 year perspectives) over the past 18 years up to June 2022 (note the June 2022 label is obscured).

And there’s no surprise that long term inflation expectations haven’t varied much, and continue to trend lower.

Chart 1 - 10 year breakeven rate, extrapolated from FRED data.

At the belly of the yield curve, i.e., the 10 year mark, the market expects inflation of 2.66% (refer per chart 1 above).

And in 5 years, i.e., the part of the yield curve where the Fed has been busy, the expectation for inflation is currently 2.94% (refer chart 2 below).

Both under 3%. Both under the long run inflation rate the Fed was targeting before COVID. And for the last 18 years, trending around the 2% level.

Chart 2 - 5 year breakeven rate, extrapolated from FRED data.

Not unsurprisingly, the inflation expectation in 10 years is not that far from where the Fed sees its 2.5% long run, or neutral interest rate, as per its June economic projections below.

June economic projections Dot Plot, extracted from Federal Reserve Press Conference on 15 June 2022.

And it’s that longer run stake in the ground that had the bond and equities markets excited last month. It was neither high nor scary and that caused equities and bond prices to rally.

However, the difference between the Fed’s predicted long term neutral rate of 2.5% and say the 10 year breakeven rate/inflationary expectation of 2.66% indicates that the bond market thinks real interest rates will be negative 16 basis points in 10 years (2.50% - 2.66% = -0.16%) and -0.44% in 5 years from now.

This view tracks with a moderately deflationary environment once the current blip in inflation has been eradicated, and that is based on improving supply chains, demand destruction, structurally lower demographics, high global debt and disinflationary technology.

The Fed says it will continue reacting to data as it comes in.

But don’t forget that the bond market has already tightened and reckons that even once inflation is back to the 2% to 3% trend, real rates will still be negative in 5 and even 10 years from now.

Are you positioned for that?

Mike

Next Level Corporate Advisory is a leading M&A and capital markets advisor with a 20 year track record of delivering the highest quality of independent financial advice as well as strategic transactions to help companies of all sizes level-up, in and out of Australia.

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