Inflation Is Usually Bad for Bonds...

Last week we learned consumers expect more inflation in coming years. The University of Michigan reported everyday folks see inflation one year from now at around 2.9%, up from 2.8% last month. More importantly for long-maturity bonds, the survey reported five- to ten-year median inflation expectations rebounded from 2.6% in November to 2.9%. The Federal Reserve takes these survey results seriously. “I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures,” said Federal Reserve Bank of New York President and permanent member of the Federal Open Market Committee William Dudley last month. He added, “Inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.” The market based 5yr-5yr forward breakeven inflation rate declined to 1.98% in response to the Michigan data release, the lowest print in five years. Therein lies the conundrum. Those surveyed expect higher inflation, while the market expects lower inflation. The market for Treasury bonds sided with breakeven inflation measures and aggressively bought ten-year Treasurys, pushing yields down seven basis points, confident inflation will remain subdued. Plummeting gas prices, which have reached a national average of $2.60 per gallon, down from $3.25 one year ago, contributed to investor demand for plain-vanilla Treasurys. The energy component of the S&P 500 declined 22% over the past six months compared to a gain of 4% for the broader index. We are in the camp that believes inflation is likely to remain low for the foreseeable future, as the middle class still struggles with low wage growth in the wake of the Great Recession. Whether U.S. growth alone can pull interest rates higher remains to be seen, but right now our evolving view is that higher rates are not the slam-dunk the market thought at the beginning of the year.
 
Sources: FRBNY, BIS, AAA, Bloomberg, University of Michigan/Reuters, SNWAM Research