Investors see risk that inflation hasn't been beaten yet

By Joseph Adinolfi

Market-based gauges of inflation expectations have ticked higher over the past couple of weeks

Concerns that inflation might not be so easily defeated are starting to creep back into financial markets

As of Tuesday, inflation swaps and Treasury Inflation Protected Securities were hinting that price pressures could linger above the Federal Reserve's 2% target, if only modestly so, for years to come. That's a notable shift from earlier this month, when both market-based gauges of investors' expectations were sliding.

The five-year breakeven rate, which gauges investors' expectations for what the average pace of inflation will be over the next five years, recently stood at 2.04%, according to the most recent data available from the St. Louis Fed, after touching a nearly four-year low of 1.86% earlier this month. The breakeven rate is obtained by measuring the difference between yields on nominal Treasurys and inflation-protected Treasurys with a similar maturity date.

A similar pattern was playing out in the market for inflation swaps, which have a more reliable track record of accurately sniffing out how price pressures might evolve. As of noon on Tuesday, one-year swaps indexed to headline CPI saw inflation at 2.028% in one year's time, according to data from Tradeweb. Five-year swaps saw a rate of 2.333%. Both have risen since their September lows.

For what it's worth, consumers also see a higher rate of inflation ahead. Average 12-month inflation expectations increased to 5.2% in September, according to the latest reading from the Conference Board's consumer confidence survey, released Tuesday.

Reflation risks

The upshot is that traders appear to be guarding against the possibility that the Fed's decision to shift more of its attention toward the labor market may have been a touch premature.

That's not to say that traders are anticipating a return to the bad old days of 2022, when global stocks and bonds wilted in the face of the worst inflationary wave in more than 40 years. When the headline CPI Index peaked that summer, it showed prices of goods and services had risen at a pace of more than 9% year over year.

Instead, the increase likely reflects the possibility that inflationary pressures might persist for the foreseeable future - albeit at a more modest level - now that the Fed has taken its foot off the monetary brake by cutting its policy-rate target by 50 basis points last week.

"They'd rather get inflation down gradually and avoid a recession, but embarking on that path means there's definitely a risk that inflationnot only takes longer to subside, but could reignite as we get into the latter part of the year," said Tim Murray, capital markets strategist at T. Rowe Price, during an interview with MarketWatch.

At the same time, investors might also be protecting against a repeat of what happened in the 1970s, when the Fed prematurely declared victory over inflation, only to see it reignite. Murray said he doesn't expect history to repeat itself. Although such an outcome remains unlikely, it's worth keeping in mind.

Even some senior Fed officials have expressed concerns that inflation hasn't yet been defeated.

Fed Gov. Michelle Bowman, who cast the lone dissenting vote against last week's cut, explained in a statement that such a dramatic first move might help to unnecessarily revive inflationary pressures.

Others have warned that the Fed's decision to opt for an aggressive cut could come back to haunt it. Steven Ricchiuto, chief U.S. economist at Mizuho, chided the central bank for risking its hard-won credibility by appearing to place its battle against inflation on the back burner.

"Accepting the tradeoff between a tighter labor market and higher inflation rate, even if the initial difference is simply accepting a 3% inflation rate over the targeted 2%, can become a slippery slope in an economy where fiscal responsibility has been all but abandoned," Ricchiuto said in commentary shared with MarketWatch on Tuesday.

Whether or not these concerns are well-founded remains to be seen. Investors will receive more information later this week when the Fed's preferred inflation gauge, the PCE Price Index, is released on Friday.

CPI data released earlier this month showed core inflation was stickier than expected in August. This was largely due to costs associated with housing rising at the fastest monthly pace so far this year.

Rising commodity prices

While this shift in the Fed's policy stance likely played a role, the modest revival in inflation expectations likely had a more immediate cause. Gennadiy Goldberg, a rates strategist at TD Securities, said the rebound in commodity prices over the past two weeks likely explained much of the move in inflation swaps.

The October futures contract for West Texas Intermediate crude (WBS.1), the U.S. benchmark, settled at $65.75 a barrel on Sept. 10, its lowest settlement since December 2021, FactSet data showed. Prices have since recovered, with the October contract trading above $71 a barrel on Tuesday.

So far, it's not just the Fed. Aggressive stimulus measures announced by China's central bank on Tuesday were also helping to boost commodity prices.

Despite this increase, Goldberg doesn't see any evidence that another potentially destabilizing wave of inflation is on its way.

"I think inflation is still trending down, but the question on everyone's minds is 'how quickly?'" Goldberg said.

So far, U.S. stocks have continued to climb, as investors have celebrated the Fed's decision to kick things off with a larger-than-usual 50-basis-point cut to its policy-rate target.

The S&P 500 SPX was up 14 points, or 0.3%, at 5,732 on Tuesday. while the Nasdaq Composite COMP was up 100 points, or 0.6%, at 18,074.

The Dow Jones Industrial Average DJIA gained 84 points, or 0.2%, at 42,208.

U.S. futures pointed to modest losses at the open on Wednesday, one day after the S&P 500 finished up 20% year-to-date for the first time in 2024.

-Joseph Adinolfi

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09-28-24 0639ET

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