How to understand the "disconnection" in U.S. inflation expectations?

Abstract

After Trump's election, concerns about "re-inflation" in the United States have intensified. Although Trump has not yet announced specific policy plans, market expectations for tax cuts and other policies have led to a rapid rise in U.S. Treasury yields. For example, the benchmark 10-year U.S. Treasury yield rose by about 15 basis points within a week after Trump's victory, approaching the 4.5% mark. In fact, this round of interest rate rebound began after the FOMC meeting in September, rising from a low of around 3.6% to near 4.5%, and the magnitude has already been quite significant.

Market concerns may not only stem from Trump's potential expansionary policies but may also include worries about the upward shift in the medium-term inflation center. Trump's election merely brought this concern forward or made it more explicit. We believe that inflation has a tendency to become endogenous, which is also what we have been describing as the "three highs" new normal of the U.S. economy—high inflation, high interest rates, and medium to high-speed growth.

The most important factor affecting medium-term inflation trends is inflation expectations. We tend to use the 5-10 year inflation expectations from the University of Michigan as a predictive anchor for medium-term inflation. When comparing the 1-year and 5-10 year inflation expectations, it becomes increasingly clear that the divergence between the two is growing, in other words, ordinary residents believe that inflation will continue to be a concern in the medium to long term.

The conflict between short-term changes in inflation and medium-term inflation expectations raises several important questions. First, the Federal Reserve will still choose to cut interest rates, but the terminal rate is likely to be at a "restrictive" level. Second, the 10-year U.S. Treasury yield will be in a relatively volatile state. Third, after the start of interest rate cuts, the market will pay more attention to related "uncertainties," leading to doubts about the effectiveness of rate cuts, which results in the "fragmentation" of rate cuts—meaning that each rate cut cannot simply lead to the next monetary policy action.

However, the market is not without certainty. For example, after a rate cut in December, the benchmark dollar interest rate will fall to a level of 4.25-4.5%, with a midpoint of 4.375%. Therefore, bonds above this interest rate level will have positive carry. While investors can imagine various possible medium-term scenarios, the importance of carry for fixed income investments is self-evident.

Main Text

After Trump's election, concerns about "re-inflation" in the United States have intensified. Although Trump has not yet announced specific policy plans, market expectations for tax cuts and other policies have led to a rapid rise in U.S. Treasury yields. For example, the benchmark 10-year U.S. Treasury yield rose by about 15 basis points within a week after Trump's victory, approaching the 4.5% mark.

Looking back at 2016, during the more than a month following Trump's election, the 10-year U.S. Treasury yield rose by more than 80 basis points, jumping from around 1.8% to 2.6%. Compared to the previous trading round, the rise in U.S. Treasury yields this time seems relatively limited, but in fact, this round of interest rate rebound began after the FOMC meeting in September From around a low point of 3.6% to approximately 4.5%, the increase has indeed been quite significant.

Of course, we cannot simply compare the two "Trump trades"; market concerns may not only stem from Trump's potential expansionary policies but may also include worries about the upward shift in the mid-term inflation center. Frankly speaking, the market may not be unfounded in its concerns. Against the backdrop of the U.S. economy consistently exceeding expectations, whether inflation can be controlled near a target level is increasingly becoming the focus of the market. Trump's election merely brought this concern forward or made it more explicit. Fundamentally, the structural changes in U.S. inflation performance compared to previous decades are the biggest worry for investors. In previous research, we described the inflation pattern in the U.S. as appearing to be in a "disordered" state, where it is difficult to accurately identify the factors triggering inflation, and there exists a high friction coefficient between the prices of various goods and services, leading to strong inflationary stickiness. Theoretically, we believe inflation has a tendency to become endogenous, which is also what we have consistently described as the "three highs" new normal of the U.S. economy—high inflation, high interest rates, and medium to high-speed growth.

At the same time, we also found that the most important factor influencing mid-term inflation trends is inflation expectations. We believe that household survey-based inflation expectations can accurately describe the actual evolution of inflation, thus we prefer to use the 5-10 year inflation expectations from the University of Michigan as a forecasting anchor for mid-term inflation. Unfortunately, this indicator shows that the U.S. mid to long-term inflation expectations have not changed significantly over the past year, remaining around 3%. Incorporating this information into our forecasting model seems to suggest that the Federal Reserve's efforts to keep inflation levels near the 2% target may be in vain.

Many investors may ask whether this means the Federal Reserve needs to raise interest rates or refrain from cutting rates until the mid-term inflation control target is achieved. This view is somewhat idealistic; the reality may be that the Federal Reserve itself is uncertain whether the mid-term inflation control target can be achieved, and there is also the possibility of "deriving" the inflation target through linear extrapolation.

From the chart below, we can also see the possibility of effective inflation control. According to the University of Michigan's 1-year inflation survey, it has been on a downward trend, and the U.S. core inflation rate (year-on-year annualized rate) has also shown a synchronous decline. Comparing these two indicators reveals that controlled inflation is not a fantasy, which is also a prerequisite for the Federal Reserve to lower interest rates. However, when comparing the 1-year and 5-10 year inflation expectations (Figure 1), it becomes evident that the divergence between the two is becoming increasingly pronounced; in other words, ordinary residents believe that inflation will still be a concern in the medium to long term. To draw an analogy to this state, for a considerable period, although housing prices may be influenced by short-term controls, most Chinese residents believe that housing prices will trend upward in the medium to long term

The conflict between short-term inflation changes and medium-term inflation expectations raises several important issues. First, the Federal Reserve will still choose to cut interest rates, but the terminal rate is likely to be at a "restrictive" level, meaning that it needs to maintain a positive real interest rate to ensure suppression of inflation. Second, the 10-year U.S. Treasury yield will be in a relatively volatile state, reflecting the market's occasional concerns about runaway inflation (just like now). Third, after the rate cuts begin, the market will pay more attention to the related "uncertainty," leading to doubts about the effectiveness of the rate cuts, resulting in "fragmentation" of the rate cuts—meaning that each rate cut cannot simply lead to the next monetary policy action.

However, the market is not without certainty. For example, after the rate cut in December, the benchmark interest rate for the U.S. dollar will fall to a level of 4.25-4.5%, with a median of 4.375%. At this interest rate level, bonds above this rate will have positive carry. While investors can imagine various possible medium-term scenarios, the importance of not losing carry for fixed income investments is self-evident.

Finally, let’s focus on the U.S. October inflation data to be released tonight. The market will likely speculate on various possible outcomes, but based on the one-year inflation expectation level already published by the University of Michigan, the probability of October's core inflation exceeding expectations does not seem high. Instead, we should ask ourselves: is Trump the devil in our hearts, or are we ourselves?

Author: Zhou Hao S0880123060019, Sun Yingchao, Source: Guotai Junan Overseas Macro Research, Original Title: “How to Understand the 'Disconnection' of U.S. Inflation Expectations?”