(Bloomberg) — Two years into the Federal Reserve’s battle against inflation, bond investors are seeing a new risk: Consumer prices are cooling too much.
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A day ahead of the August inflation report, one gauge of expectations of consumer price index increases is showing that prices are in danger of falling below the Fed’s target. The central bank has long argued that persistently low inflation is as detrimental to the economy as elevated prices because it would force policymakers to keep borrowing costs too low for too long, reducing the Fed’s ability to fight off economic downturns.
“Market participants are sensing that the inflationary surge is now fully over, and there’s some chance here now, with the balance of risk being shifted to the employment mandate, that the Fed undershoots its inflation target,” said Tim Duy, chief US economist at SGH Macro Advisors. “You do have to take those risks fairly seriously.”
The so-called 10-year breakeven rate fell to 2.02% on Tuesday — the lowest closing level since 2021. That suggests investors see inflation averaging over the coming decade below the Fed’s 2% goal since historically CPI runs about 40 basis points above the preferred Fed target metric, the personal consumption expenditures price index.
The rate is calculated based on the difference between the yield on inflation-protected securities, or TIPS, and standard Treasuries. The falling measure is driven by the yields on the nominal bonds falling faster than the TIPS, which typically are less traded than regular bonds.
Strategists also note some technical factors are at play, including low liquidity in US inflation-linked debt and a sharp decline in oil prices. Still, they warn the breakeven rate shows concern that the central bank may have been too slow to ease policy.
Treasuries have been rallying since the end of April as signs of cooling inflation and labor market cemented expectations that the Fed next week will deliver its first rate cut since 2020. Yields on 10-year notes touched 3.64% Tuesday, the lowest since June 2023 as Brent oil dropped below $70 a barrel.
The debate now is how fast the Fed should bring down the benchmark rate — currently in a range between 5.25% and 5.5% — to safeguard the economy. Interest rate swaps showed that traders have fully priced in a 25-basis-point Fed cut at the Sept. 18 meeting and see 20% of a chance for a jumbo half-point reduction.
In addition to the longer-term inflation outlook, Angelo Manolatos, a strategist at Wells Fargo Securities, said inflation swaps contracts are showing an even more dire outlook in shorter horizon.
The one-year swaps suggested traders are betting that consumer prices will only rise about 1.7% over the next 12 months. That would mark a sharp slowdown. The August report is expected to show consumer price increased 2.5% from a year earlier — down from a 2.9% pace in July and a peak of 9.1% in June 2022.
“These moves show the Treasury market pricing in higher risk of a hard landing,” said Manolatos. “The takeaway is also that there is definitely no inflation risk premium to be seen, even though we just saw a 9% handle on CPI just a few years.”
Some strategists say the recent decline in the breakeven rate has gone too far, too fast. Barclays Capital’s Michael Pond advised clients positioning for a steeper breakeven curve in the forward market, saying investors are underestimating longer-term inflation risks.
Societe Generale’s strategists led by Subadra Rajappa last week recommended their clients betting that the five-year breakeven rate will rise. She said in a note that it’s rare for the average CPI inflation to drop below 2% over a five-year period, even in the event of a recession. That occurred only 24% of the time since 1945.
Since the Fed is attentive to “excessively low” prices, it is attractive to “buy inflation protection while it’s inexpensive,” she added.
–With assistance from Carter Johnson.
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