The Bond Market Says That Inflation Is Transitory

By: Steve Sosnick, Chief Strategist at Interactive Brokers

Markets are abuzz this morning with talk of inflation. The Bureau of Labor Statistics (BLS) released the Consumer Price Index (CPI) data for January, and they proved to be even worse than economists expected. The headline was that the CPI rose 7.5% over the past year, above the 7.3% expected, while the so-called “core CPI”, the reading that excludes more volatile food and energy prices, rose 6.0% versus a 5.9% expectation. Investors did not appreciate the higher-than-expected results and acted accordingly. Stock and bond prices both dropped precipitously, though stocks recouped most of their losses within about an hour.

Fixed-income traders are distracted far less easily. Remember, government bond traders have little else to consider besides money flows and inflationary expectations. There are no memes in the T-Note market, let alone credit concerns on a day-to-day basis. Even the slight headline misses were enough to push rates higher across the curve, with the front-end bearing the brunt of the damage. The 2-Year Note yield rose over 13 basis points (bp) to push those yields to the brink of 1.5%. Bear in mind that the yield was 0.90% just a month ago and 0.73% at the start of this year. Yes, the 2-Year T-Note yield has more than doubled in about six weeks!

Immediately after the December 2021 FOMC meeting we questioned whether the bond market was heeding the Federal Reserve’s message, asserting that 2-Year rates were inadequately discounting the likelihood of numerous rate hikes before those notes matured. At that time, those notes were yielding a mere 0.625%. Now the 2-Year yield is matching the dot plot’s 1.5% median projection for year-end 2023. It is possible that bond traders may have flipped from too sanguine to too cautious in just two months.

Over the same time period, 10-Year yields have risen by a smaller magnitude, moving from 1.41% to 2.01%. That means that the 2-10 spread has fallen from just under 80bp to 50bp. Interestingly, KRE, the SPDR S&P Regional Banking ETF is up about 15% in that time frame. In December we also noted that KRE had detached from the 2-10 spread after following it closely from April 2020 through the summer of 2021. The ETF clearly remains detached from the interest rate spread that is a key to the profitability of their lending activities – to the benefit of those who continue to favor bank stocks.

Yet there is a highly important message being sent by the 10-Year yield – that the market believes that inflation is indeed transitory. How else can one explain why inflation could run at a 7% rate in the short-term yet yield far less in the long term? Short-term rates can be explained by the market’s expectations for the Fed Funds rate over the ensuing months, but inflationary expectations come into play at the longer end of the yield curve. The current message being sent by the bond market is that the Fed will raise rates sufficiently over the ensuing two years to largely stamp out future inflation in the ensuing eight years.

While I have little doubt that we are seeing levels of inflation that are difficult to sustain over the long-term, I am similarly skeptical that Fed rate hikes of 1.5-2% over the coming 2-3 year period will miraculously squash inflationary expectations completely. This is the ultimate expression of the idea that inflationary pressures are indeed transitory. Chair Powell may have made the term “transitory” verboten, but that is an adequate descriptor if the market assumes that inflation will ebb dramatically after a couple of years of Fed action.

It appears that bond traders have also gotten the message “Don’t Fight the Fed,” since they are clearly loath to assume that inflation will persist beyond the near term. Another possibility – also a version of “Don’t Fight the Fed” – is that the pace of bond purchases by the Federal Reserve is not slowing at the pace stated in recent FOMC statements. We saw evidence that the tapering was occurring much more slowly than the Fed would have us believe, with the holdings of securities on the Fed’s balance sheet continuing to grow by over $100 billion per month. Until the Fed eliminates its still-relentless bond buying the message from the bond market will remain murky.

Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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