Based on where Treasurys are trading, you might have no clue that inflation was close to a six-year high.
Price pressures can ravage the value of long-dated debt, the corner of the bond market most sensitive to inflation. Yet even as consumer prices have steadily risen, hitting a year-over-year 2.9% pace in June, yields for long-end Treasurys have not risen but have stayed range-bound, leaving debt prices well-supported. Yields and prices move inversely.
Market participants argue Treasurys aren’t writing off the inflation upsurge. Rather, current yields at the long end reflect investors’ expectations for consumer prices to turn lower by the end of the year, maintaining a downward trend well into 2019. Standish Mellon’s economists forecast CPI to rise 2.4% for 2018 but cool to 2.3% in 2019.
“It’s pretty much as expected. The June inflation number doesn’t change the underlying backdrop,” said Brendan Murphy, head of global and multi-sector bonds at Standish Mellon. “Investors aren’t expecting inflation to accelerate,” he added.
The 10-year Treasury yield TMUBMUSD10Y, +0.06% stands at 2.853%, back to levels where it started in February, the endpoint of its breathless 60-basis-point climb from last September. The 30-year bond yield TMUBMUSD30Y, -0.18% is at 2.954%, 15 basis points away from its starting levels this year, even after two Federal Reserve interest-rate hikes have been passed. Fed moves are usually more acutely mimicked along the shorter end of the yield curve but, and especially if they accompany rising inflation expectations, higher rates can be reflected along the yield curve.
The bond market’s muted expectations for inflation show up in breakeven rates, which loosely measure a market’s sensitivity to interest-rate shock. Indicating the bond market’s forecast for CPI over various periods, the breakeven rate for five years is at 2.05%, marginally below the 10-year rate of 2.12% and the 20-year rate at 2.09%. In other words, this flat breakeven curve backs the theory that investors believe the recent upswing in prices will prove temporary.
This growing view among buyers of Treasurys is supported by two points on inflation.
For one, wage growth remains missing from the picture. The jobs report for June showed average hourly earnings rose 0.2%, keeping the year-over-year rate at 2.7%. Though wages are on the rise, they have struggled to keep up with inflation, suggesting an erosion of consumers’ purchasing power.
“We haven’t seen wage pressures materialize,” said Geoffrey Caan, managing director of U.S. public bonds at Sun Life Investment Management.
That could keep away the demand-driven inflation the Fed needs to justify its rate-hike path, unlike the flare-up in producer prices that is squeezing the margins of businesses struggling to pass higher costs to consumers. Producer prices in June rose to a year-over-year rate of 3.4%, their highest since 2011.
Two, the impact of a trade war on inflation isn’t clear. Investors say tariffs may push up prices in the near term, but if a trade conflict dislodges the global economy’s momentum, inflation might weaken over the longer run.
“The escalating tariffs war between the U.S. and the rest of the world is disrupting global supply chains and increasing the cost of imported goods in the short term. However, it could also spell the end of the reflation story that has supported the markets since February 2016,” said Sophie Huynh, cross-asset strategist at Société Générale, in a Thursday note.