By Richard Leong
NEW YORK (Reuters) - The U.S. bond market shows investors are confident that inflation has picked up from last year's low levels, but they are not so sure it will head much higher from here.
The muted outlook comes as Federal Reserve officials at a two-day policy meeting that began on Tuesday are likely discussing whether they should stick with their path on raising key short-term interest rates or quicken the pace of rate hikes as the U.S. economy approaches full employment.
"If you take a 30,000-feet view, near-term inflation is recovering, but with long-term inflation, the market is not buying it will pick up much," said Boris Rjavinski, senior rate strategist at Wells Fargo (NYSE:WFC) Securities in New York.
Yield spreads between regular Treasuries and Treasury Inflation Protected Securities (TIPS), also known as inflation breakeven rates, on Wednesday were running at 2.03 percentage points to 2.10 percentage points across maturities, according to Tradeweb.
Earlier this month, the five-year, 10-year and 30-year TIPS breakeven rates hit 2.15 percent, 2.13 percent and 2.13 percent, respectively, their highest levels since December 2015.
This inversion of breakeven rates, where short-dated rates are higher than longer-dated ones, "reflects an acceleration of inflation expectations in the short term while overall expectations continue to rise," according to Tradeweb.
TIPS breakeven rates fell sharply in the first half of 2017 on a string of disappointing inflation readings, but recovered in the second half as inflation numbers improved and the passage of tax overhaul in Washington seemed likely.
FLATTENING YIELD CURVE
The slim difference in TIPS breakeven rates is just one market indicator that reflect investors' tame outlook on inflation despite the tax code overhaul in December and a two-year budget agreement in February.
The narrowing of short-dated and long-end bond spreads, which are hovering at the tightest levels in a decade, also support notion of investors' muted inflation outlook.
U.S. consumers seem to agree with investors' assessment that inflation remains a distant threat.
University of Michigan data on Friday showed consumers' inflation outlook for a year from now rose to 2.9 percent in early March from 2.7 percent in February, but that their five-year view was unchanged at 2.5 percent.
UNCERTAIN INFLATION OUTLOOK
The two recent developments from Washington are expected to boost business and consumer spending and ratchet up federal borrowing, which would spur inflation.
Those developments, however, have been offset by views of the impact of U.S. President Donald Trump's efforts on imposing tariffs. They have stoked fears of a trade war that could increase costs for domestic consumers but hurt U.S. exports and weigh on long-term economic growth.
"It's made people more pessimistic in the long run," said Aaron Kohli, interest rate strategist at BMO Capital Markets in New York.
Several Fed policymakers and economists argue that with underlying inflation measures still short of the Fed's 2 percent goal, there is no urgency for the U.S. central bank to boost the pace of rate hikes.
Back in December, the average expectation among Fed officials was for three rate increases for 2018.
Inflation, while showing a modest pickup in recent months, is far from flaring up.
The Labor Department said a week ago its consumer price index rose 0.2 percent last month after jumping 0.5 percent in January. In the 12 months through February, the CPI rose 2.2 percent, up from 2.1 percent in January as the flat reading from last year dropped from the calculation.
The annual increase on the core rate on personal consumption expenditure, the Fed's preferred inflation gauge, was unchanged at 1.5 percent in January which continued to run below 2 percent since May 2012.
"There is some progress no question but they will counter balance it because they haven't seen a sustained recovery to the 2 percent," Well Fargo's Rjavinski said of uptick in inflation so far this year.
