Worried about out-of-control inflation? The bond market has a message: Relax

January 20, 2022, 10:00 AM UTC

A lot of investors are freaked out about swelling inflation, which they fear will bedevil them far into the future. The consumer price index (CPI) jumped 7% in December, from 12 months before, the highest spike since June 1982. This escalation hits people on two levels. The cost of everyday items like groceries is climbing. And interest rates typically rise during inflation surges, affecting retirement savings, monthly payments for new mortgages, and other loans.

So how bad will this get?

Maybe not so bad, if the bond market is correct. Bond yields “tell us there will be a lid on inflation,” says Marcus Dewsnap, head of fixed income at Informa Global Markets. Look at the so-called breakeven rate, which forecasts average annual inflation over the next five years of 2.82%. The metric measures the difference between rates for five-year Treasury notes and Treasury Inflation-Protected Securities, or TIPS. This number is somewhat close to the Federal Reserve’s own forecast of 2.6% for 2022 and 2.3% for next year.

Those levels of just below 3% are way down from the shocking December CPI report. Yes, the latest estimates are north of what of the public got used to over the last couple of decades, 2% or less. Still, they’re nothing like the double-digit CPI increases that plagued the 1970s and early 1980s. Besides, the nation has shown it can live with 3%. During the early 1990s, the CPI rose around 3% without harm to the economy.

Yield curve swerve

The bond market’s reaction to current inflation is one big shrug. Check out what has happened to the so-called yield curve, which plots the difference between short- and long-term Treasury rates. Amid all the inflation news and the Federal Reserve’s announcement it will jack up short rates, the two-year and 10-year Treasuries have had just moderate increases. The gap between the two, called the spread, has hardly changed much over the past year. Back in January 2021, the spread was 0.97 percentage point; lately, it’s 0.79 point.

Although the dynamics of short- and long-term bonds differ, the message they send is the same: Don’t expect big increases in their yields because inflation is coming down. A Bloomberg survey of Wall Street strategists finds they expect the two-year to reach 1.12% ( from 0.99% now) and the 10-year to inch up only to 2.04% (from the current 1.78%), by year-end.

The Fed holds greater sway over the short end of the bond spectrum, and it is expected to start raising its benchmark Federal funds rate, now near zero, in quarter-point increments starting in March. The Fed funds futures market indicates a 60% probability that four hikes will occur this year.

The Fed also is aiming to help longer-term bonds’ yields go higher by ending the agency’s pandemic-rescue campaign to buy them at a $120 billion monthly clip. The Fed’s plan: Through gradually tapering those massive purchases to nothing by summer, the central bank removes downward pressure on yields. (All the buying has been raising bond prices, which move in the opposite direction from yields. So once the biggest buyer exits the market, bond prices should theoretically fall, and yields will once again rise.)

What could go wrong?

True, other forces may well blunt that initiative. That tapering plan isn’t sufficient to make yields go up much, according to a Northern Trust study. The Fed’s idea fails to take into account the vast appetite for the 10-year from institutional investors worldwide, the firm argues. Its report cites the “insatiable and durable demand that pensions, insurance companies (among others) have for longer-dated bonds” from Washington.

The bond market may be sending reassuring signals, yet that doesn’t mean that investors can rest easy this year. “What if another variant comes along?” asks Steve Hooker, portfolio manager at Newfleet Asset Management. And what if the current spate of wage increases keeps inflation higher than consumers can live with?

Beyond that, the Fed is far from infallible. It and other central banks were not very good at lifting inflation to their 2% target pre-pandemic. Who’s to say they will be any more effective curbing spiraling prices these days? “Inflation will be much worse for the longer term than you think,” declares Marilyn Cohen, president of Envision Capital, a bond specialist.

But will it? At the moment, the market has considerable faith in the Fed. The economy has shown that it is resilient. The inflationary pressures of four decades ago are absent. And a lot of smart people are betting big money that inflation is not going to be as big a deal going forward as recent headlines may have led you to believe.

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