Several indicators suggest fixed-income investors are rightfully skeptical of recent signs suggesting pricing pressures are running too high.
As shown in our LPL Chart of the Day, shorter-term break-even inflation rates have dropped to their lowest levels of the year, implying market expectations for persistent inflation continue to dwindle, even amid the strongest Consumer Price Index (CPI) and Producer Price Index (PPI) readings of the economic cycle. Break-even rates are the difference between the yields of nominal Treasuries and yields of Treasury Inflation-Protected Securities (TIPS), and are used as a gauge of the fixed-income market’s forecast for inflation rates over a period of time.
To us, rates markets are taking cues from core personal consumption expenditures (PCE) and wage growth, inflation measures historically watched by the Federal Reserve (Fed). While recent CPI and PPI reports point to steady inflation, PCE and wage growth still lag target levels set by monetary policymakers.
“Even though signs of price and wage pressure have been building, we believe the overall pricing environment may not prove as threatening as many investors fear,” said LPL Research Chief Investment Strategist John Lynch. “It’s apparent to us that too many investors are confusing the Fed’s target for price stability with runaway inflation.”
Longer-term yields, which typically follow expectations for inflation and economic growth, have also struggled over the past several months, reflecting investors’ hesitations around the pace of price and wage growth. The 10-year Treasury yield fell 10 basis points (0.10%) Wednesday through Friday of last week, its steepest 3-day drop since May, even as CPI and PPI reports were released. The 10-year yield has also tumbled back below 3%, a watermark this year given subdued inflation, after closing above that level on August 1 for the first time since May.
Overall, we expect longer-term yields to grind slightly higher through the end of the year, with the 10-year yield finishing 2018 in a range of 2.75% to 3.25% (As mentioned in the Midyear Outlook 2018: The Plot Thickens). We also believe there is ample time before inflationary pressures begin to weigh on output or force the Fed to alter its plans for monetary policy. We recognize that a meaningful upside surprise in inflation could lift rates higher, but for now, we don’t foresee that happening.
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