Tuesday, June 14, 2022
To say the bond market didn’t like Friday’s (June 10) consumer inflation report would be an understatement. After the report showed headline inflation at the highest levels since the 1980s, yields across the front end of the yield curve moved sharply higher with the 1-year, 2-year and 3-year maturities moving more than 20 basis points higher for the day. Moreover, the selloff continued into Monday with front end yields up another 30 basis points—the 60 basis point jump over the last two trading sessions for the 2-year Treasury is the largest since the early 1980s and larger than the jump that happened after the Lehman Brothers collapse. Front end yields are more sensitive to changing monetary policy expectations so the move higher in yields is based upon another aggressive repricing of Federal Reserve (Fed) rate hiking expectations. As seen in the LPL Chart of the Day, markets are now expecting an increase of nearly 200 basis points (2.00%) in the Fed funds rate over the next three meetings including the meeting this week. Markets now expect the Fed to take its short-term interest rate above 3.6% by year end. The 360 basis point increase in interest rates would be the most in one year since 1980.
“The selloff in the Treasury market has been historically awful this year,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Inflation expectations remain relatively anchored and financial conditions have tightened meaningfully already this year so maybe the Fed won’t have to hike as many times as the markets are expecting. That should help provide a lift to both stock and bond prices.”
But the question remains does the Fed need to be as aggressive as markets are expecting? Moreover, has the Fed lost control of the inflation narrative? If you were to look at both market-implied inflation expectations as well as the recently released survey data from the Federal Reserve Bank of New York, the answer is maybe not. As seen in the chart below, market-implied inflation expectations remain relatively well anchored. While near term expectations remain elevated, particularly over the five-year horizon, they remain below the peak seen earlier in the year. Also, average five-year inflation expectations beginning five years from now (2027-2032), a metric the Fed relies on to look through current price pressures, remains within historical averages. As for the survey data, one-year ahead inflation expectations as measured by the New York Fed remain elevated but three-year ahead inflation expectations were steady at 3.9%– again elevated but likely not enough to worry the Fed about unanchored inflation expectations.
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