Inflation Expectations on the Rise

February has brought volatility back to the capital markets after a period of relative stability.  Today I want to focus on the bond market because very often what happens in the bond market determines what happens in the stock market.  The first chart below shows that interest rates rose abruptly starting in the beginning of February after a downward trend that began in early November of last year.   Perhaps more interesting, though, is the fact that the yield curve has become more inverted (gray line in the chart) even as interest rates have reversed course.  The abrupt spike in rates suggests that investors may be worried about inflation, but the extreme inversion in the yield curve suggest a high probability of a recession ahead.  Which is it?  Could we be at risk of a simultaneous resurgence in inflation and an economic contraction?  

The next chart is another way of showing that inflation fears abruptly spiked over the past few weeks.  “Breakeven” inflation rates are market-based indicators of inflation expectations.  In other words, if the 5-year breakeven inflation rate is at 2.62%, which is its current level, that means bond investors believe inflation will average 2.62% over the next five years.  That may not seem like a big number, but it’s up from just 2.13% on January 18^th.  And perhaps the bigger concern is that nobody knows when the breakeven rates will stop going up.  Faced with rising uncertainties, investors are prone to sell first and ask questions later. 

The final chart below shows that the markets are pricing in a much higher terminal, or peak, Fed Funds rate as compared to just a few weeks ago.  As I write, the Fed Funds rate is expected to peak at around 5.37% in July of this year, up 0.54% since February 1^st.  While this is a pretty big move, it pales in comparison to the 2.23% increase from mid-2022 to the previous peak in November.  But here again, nobody can be sure where this upward trend will end, and that makes investors nervous. 

The broader interpretation of this data is pretty straightforward.  Beginning in late January to early February, after about four months of complacency, the markets started to worry about inflation again.  Interest rates have spiked all along the yield curve, breakeven inflation rates have risen significantly as well, and the terminal Fed Funds rate (in July, 2023) is up by over 0.50%.  This is a stark change from the previous four months when we saw interest rates and breakeven inflation rates trend lower while expectations for Fed rate hikes trended down.  The abrupt change in these trends is concerning for all investors, especially given that stocks are trading at relatively full valuations.  Nobody is quite sure how big the inflation problem is or when the threat will end.  Recent data, particularly relating to the labor market, suggests the consumer remains resilient.  And as long as consumers feel confident and have the means to keep spending, they will.   

Taken together, the bond market data may also be signaling something potentially ominous.  The sharp and ongoing rise in the breakeven inflation rates in the face of a higher Fed Funds terminal rate suggests that investors may have lost confidence in the Fed’s ability to contain inflation.  If that is indeed the case, the Fed might have to act more aggressively to gain control of the narrative again.  That’s why we are beginning to hear about the possibility of larger 50 basis points rates hikes.  I hope this sheds some light on the recent volatility in the stock and bond markets.  It is a very interesting time where strong economic news (e.g. lower unemployment, strong wage gains, etc.) is considered a negative because it means that the Fed has more work to do on inflation.  Things usually turn out better than feared, but the increase in uncertainty surrounding inflation and interest rates is sparking investor anxiety once again.  As always, we remain fully-invested in diversified portfolios of high quality stocks and bonds that are designed to endure while times are tough and prosper once the clouds have cleared.