Bond market indicators sound the alarm: Inflation may fall below the Federal Reserve's target

The Federal Reserve has been fighting high inflation for over two years, and now bond market investors have discovered a new danger: inflation may fall below the Fed's target level.

On Tuesday, September 10th, the 10-year breakeven inflation rate reflected by U.S. bonds fell to 2.02%, the lowest closing level since 2021. This indicates that investors expect the average inflation rate over the next decade to be below the Fed's inflation target of 2%. Historical records show that the Consumer Price Index (CPI) is typically about 40 basis points higher than the Fed's preferred inflation gauge, the Personal Consumption Expenditures (PCE) price index.

The breakeven inflation rate is calculated from the yield spread between Treasury Inflation-Protected Securities (TIPS) and standard U.S. Treasury bonds. The decline in this indicator is due to the nominal U.S. Treasury bond yields falling faster than TIPS. For the Fed, the prospect of lower inflation than expected is not good news. The Fed has long believed that persistent low inflation poses as much risk to the economy as rising prices, as it would force the Fed to keep borrowing costs too low for too long, weakening its ability to combat economic downturns.

Tim Duy, Chief U.S. Economist at SGH Macro Advisors, commented that market participants feel that the surge in inflation has now completely ended, and the focus has shifted to employment. The risk now is that the Fed may have overdone the inflation reduction, and now "this risk must be taken very seriously."

Some strategists believe that in addition to the decline in U.S. bond yields, the drop in the breakeven inflation rate is also influenced by factors such as the low liquidity of TIPS linked to U.S. inflation and the recent sharp drop in oil prices. However, they warn that the breakeven inflation rate indicates that investors are concerned that the Fed's monetary easing actions are too slow.

Fed Chair Powell sent a dovish signal at the Jackson Hole central bank symposium in August, and it is widely expected that the Federal Open Market Committee (FOMC) meeting this month will decide to cut interest rates. The market's divergence lies in how quickly the rate cut can avoid an economic downturn. Prices of interest rate swaps indicate that traders have fully priced in the possibility of a 25 basis point rate cut by the Fed this month, with only a 20% chance of a 50 basis point cut.

In addition to the long-term outlook for inflation, Angelo Manolatos, a strategist at Wells Fargo Securities, pointed out that the short-term inflation expectations reflected in inflation swaps are more severe. The one-year swap contract indicates that traders are betting that the CPI will rise by only about 1.7% in the next 12 months, while economists expect the U.S. August CPI to be released this Wednesday to increase by 2.5% year-on-year, slowing from 2.9% in July and far below the peak of 9.1% in June 2022.

Manolatos stated that these trends indicate an increase in the pricing of hard landing risks in the U.S. Treasury market. There was no inflation risk premium seen even when the CPI was as high as 9% a few years ago.

Some strategists believe that the recent sharp decline in the breakeven inflation rate is too much and too fast. Barclays strategist Michael Pond advised clients to position themselves in the forward market for a steeper breakeven curve, stating that investors are underestimating longer-term inflation risks. Societe Generale strategists recommended clients to bet on a rise in the five-year breakeven inflation rate, pointing out that even during economic recessions, it is rare for the five-year CPI inflation to fall below 2%, with only a 2% probability of this happening since 1945 Last Friday, the whistleblower of high inflation in the United States and former Treasury Secretary, Summers, stated that the non-farm payroll report for August released that day was not particularly bad, and the data definitely did not show any obvious weakness. He currently predicts that the United States will not fall into an economic recession. Wall Street News subsequently mentioned that if this is indeed the case, then the financial markets' expectations for future easing by the Federal Reserve are too high.

On the same Friday, the yield on the two-year U.S. Treasury bonds, which are sensitive to interest rates, fell below 3.60% intraday, hitting a new low since the Silicon Valley bank collapse in March last year triggered a crisis in the U.S. banking industry