By Karen Brettell and Karen Pierog
(Reuters) - U.S. Treasury investors are pricing for an uptick in inflation as the American economy recovers from devastating coronavirus-related business shutdowns. And, with the Federal Reserve welcoming the rise as price pressures stay benign, analysts say the increase in inflation expectations may still have further to run.
Breakevens on 10-year Treasury Inflation-Protected Securities (TIPS), which measure average annual inflation expectations for the coming decade, have jumped to 2.19%, the highest level since mid-2018.
The breakevens briefly dipped below 2% last month on profit taking, before rising again.
Traders are betting that prices will increase as the U.S. economy returns to more normal levels in the second half of this year, after contracting at its deepest pace since World War Two in 2020.
“Everything’s hot right now,” said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia, noting improvements in manufacturing, the service sector, the labor market and housing. “It’s the first time in many years that so many factors have leaned towards the inflationary side of the fence.”
The prospect of a new coronavirus relief package is adding to the move. Democratic President Joe Biden's drive to enact a $1.9 trillion COVID-19 aid bill gained momentum early on Friday as the U.S. Senate narrowly approved a budget blueprint allowing Democrats to push the legislation through Congress in coming weeks with or without Republican support.
Fed officials support the rise in inflation expectations, and the U.S. central bank has said it will let price pressures run higher for longer before hiking rates, in order to make up for years of below-target inflation.
Indeed, while TIPS are suggesting the consumer price index (CPI), which rose 1.4% on the year in December, will rise over 2%, the Fed’s preferred measure of inflation - personal consumption expenditures (PCE) - has historically run around 30 to 50 basis points lower. That would be still below the Fed’s 2% target.
“We’re not at levels that are particularly high relative to a 2% PCE outlook,” said Michael Pond, head of global inflation-linked research at Barclays (LON:BARC) in New York.
Inflation expectations are also getting a boost because it won’t be made clear whether a rise is likely until the economy goes back to normal.
“Regardless of the near-term outlook, and where inflation is actually printing, the reflation story won’t be proven wrong until in our view deep into the second half of the year,” Pond said.
A further near-term boost in expectations is likely as last year’s inflation readings from before March fall out of the year-on-year comparisons, making annual increases appear more impressive.
“That will create the appearance of rising inflation, and I’m willing to bet that bonds will trade off of that appearance,” said LeBas.
That said, the runup in inflation expectations may disappoint investors if inflation fails to materialize.
"This is a gigantic head fake in the markets,” said Robert Tipp, chief investment strategist at PGIM Fixed Income in Newark, New Jersey.
Tipp said that breakevens could continue to rise this year, but that he doesn't think they will top the 2.50% level.
"Investors think you're going to go back to the 2018-2019 world where the economy is really hot," Tipp said. "What they're missing is that for the entire last 40 years and at an accelerating pace the demographics are becoming weaker and growth is becoming slower."
TIPS breakevens are also being helped by supply and demand factors as the U.S. Treasury ramps up issuance of nominal Treasuries to pay for fiscal spending, but increases the size of TIPS issuance at a slower pace.
That comes as the Fed continues to buy large amounts of inflation-linked bonds. And the market is less liquid than that for nominal Treasuries, which can exaggerate price moves.
“One factor that has certainly enhanced the widening of breakevens has been the relative illiquidity of TIPs,” said Michael Lorizio, senior fixed income trader at Manulife Investment Management in Boston.
The market’s relative illiquidity, however, could pose a risk if sentiment turns away from higher inflation later in the year.
“That factor can work as an accelerant in the opposite direction, as well, obviously, if the tone of the market shifts,” Lorizio said.