The inflation of the US bond market seems increasingly vulnerable

(Bloomberg) — There is growing concern that the bond market has lowered inflation risks too far.

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The sharp drop in yields over the past two months is mainly due to lower inflation expectations. This means that the so-called real returns, protected from inflation, have fallen less than their nominal counterparts. Its lagging performance reflects diminishing demand for protection against price hikes.

The broader bond market also indicates that a Fed policy rate peak of less than 5% would be enough to cause a recession, requiring rate cuts of up to half a point during the second half of the year. Some argue that there is not much margin for error anymore. Strong demand at this week’s auction of the 10-year Treasury Inflation-Protected Note indicates that investors are listening.

“For months, people have been convinced that inflation is behind us, and so there has been a huge rush into bonds,” said Ben Emmons, senior portfolio manager at NewEdge Wealth. If China’s reopening causes inflation to rise or a recession does not materialize, that will be a problem.

The relative real and nominal Treasury yields reveal the expected average rates of increase of consumer prices over the life of the bond. As for the 10-year note, it hit a year-low low this week, 2.09%. The five-year inflation rate fell to 2.13%, within a basis point of last year’s low.

“In bonds, kryptonite is inflation,” said Jack McIntyre, portfolio manager at Brandywine. “Our thesis is that the peak of inflation is in the rearview mirror and we think that by the middle of the year or later there will be evidence that the economy is really weakening and that inflation is melting. There is still a lot of tightening to hit the economy at a time when it is already slowing. At this point, I don’t see A reason to take a bearish stance on bonds.”

Those assumptions have helped drive the broader Treasury market to a yield of 3.1% so far this month, which is a historic rebound from last year’s loss of 12.5%. Earnings across the nominal curve declined as much as 44 basis points, led by the five-year period. 5 to 30 years old is less than 3.8%.

“The bond market has gotten off to a very hot start this year, and it should cool off,” said Alan Ruskin, chief international strategist at Deutsche Bank. “There are limits on how low Treasury yields can go from here if the Fed goes to 5%.”

The competing view on inflation is that break-even rates “once again look exponentially cheap” based on trends in commodity prices and credit spreads, JPMorgan Chase & Co. inflation analyst Phoebe White said in a Jan. 19 report. Federal Reserve Governor Christopher Waller said on Friday that financial markets are overly optimistic about how quickly inflation will recede.

Waller said inflation “will not miraculously go away.”

In one sign that investors are having second thoughts, they flocked to Thursday’s 10-year Treasury Inflation Protected Securities, or TIPS. The auction attracted a yield of 1.22% — about 4 basis points below that it was trading at the bidding deadline, a sign of demand exceeding expectations. Primary merchants were given a record low share of 7.6%, sidelined by customer offerings. The bids totaled 2.79 times the amount offered, the highest since 2019.

Interest rate analysts at TD Securities this week recommended betting on an increase in the two-year break-even inflation rate from around 1.95% to 2.65%. Priya Misra, head of global interest rate strategy at TD, said in a note that the advance in inflation rates mainly reflects commodity prices, while the rate of growth in non-housing services “is likely to be flat on the way down.”

Inflation for personal consumption expenditures excluding food and energy, which the Fed prefers over the consumer price index, rose 4.7% year-on-year in November. The December reading on Friday is expected to drop to 4.4%. TIPS breakevens target the CPI, which tends to be hotter than PCE.

“I think yields are pretty low here, pricing is in a pretty steep slump in 2023,” said Michael Aron, chief investment strategist at US SPDR of State Street Global Advisors. “And I agree with the fact that inflation will continue to be volatile and very strong this year, but it will still be above the Fed’s target. So I don’t think the Fed will cut interest rates in 2023.”

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