Data as of March 11, 2021. Sources: Bloomberg, U.S. Treasury, WTIA.
Equally as important as the familiar nominal yield are the underlying drivers. Long-term interest rates are driven, among other things, by expectations of real growth in the economy (embodied in the real yield) and by expectations of inflation. Most of the gain since mid-2020 has been driven by rising inflation expectations. Only in the last few weeks have fixed income markets shown a pickup in real yield.
While the anticipated higher inflation dealt a blow to fixed income, it has been a boon for equity markets, though unevenly. As my colleagues recently detailed, higher inflation, higher interest rates, and a steeper yield curve are boons for specific equities in the values and cyclicals categories, among others. But if inflation runs too hot and threatens to snowball, equities may be at risk if the Federal Reserve is forced into action.
We do expect inflation to pick up over the course of 2021, possibly ending the year as high as 3%, despite another weak inflation report earlier this week. We expect to see higher year-over-year readings in March, April, and May, but that is mostly a head-fake, and is due to comparisons with the COVID-induced shutdown months last year. More to the story of true inflation: a vaccinated public with more than $2 trillion in savings and more stimulus on the way will push inflation higher in the second half of the year.
But we don’t expect it to gather steam and snowball inexorably. As CIO Tony Roth and I discussed in a podcast as part of this year’s Capital Markets Forecast, such a snowballing effect requires consumers, firms, and markets to believe prices will continue to accelerate. In a self-fulfilling prophecy, they would react by demanding higher wages, pushing through higher prices for products, and driving interest rates ever higher, respectively.
The looming Fed
At the moment, consumers and financial markets have that same view. The inflation breakeven rates described above for the next 10 years can be broken into segments, the first five years and then the subsequent five years. Throughout the past eight years markets have priced in lower inflation in the first five years than in the subsequent five years (orange line below the grey line). That has flipped in a meaningful way in recent months, with higher inflation now expected in the near-term, which can be seen as the most recent data points on the far right of the chart. Though markets are pricing in 2.5% inflation over the next five years, the highest since 2008, they are also expecting inflation to fall back down closer to 2% thereafter.
The Fed likely sees this as a victory, at least for the moment, as this is the exact dynamic they are trying to engineer following the changes made to their official operating policy last August. As a bonus, consumer surveys are reflecting similar expectations of higher inflation in the near term, but to come back down later as shown in the figure farther down.
Bond market expected inflation (%)