Market-based inflation expectations jump, adding to list of upside risks

By Vivien Lou Chen

A market-based measure of future inflation expectations is back near the top of its 10-year range, raising the possibility of more upside risks to price gains that could rattle financial markets.The 5-year, 5-year forward inflation expectation rate tracks expectations for average inflation in the five-year period that begins five years from today. That rate, which reflects the period between 2028 and 2033, is now trading close to 2.5% or near the top of the levels that have prevailed since 2013. Policymakers care about this gauge because it ignores any developments between now and the next five years that could distort signals about longer-term trends.

More troubling than the almost 2.5% level itself, however, is that the 5y5y rate, also known as 5y5y forward breakevens, began to pivot about 20 basis points higher around mid-July -- albeit in a choppy manner -- despite no major developments, according to macro strategist Will Compernolle of FHN Financial in New York. In other words, future expectations drifted higher in the absence of any big news, marking a "huge inflection point," he said via phone on Wednesday.

The change in the 5y5y forward rate "can be added to the list of concerns as to why there may be upside risks to inflation," Compernolle said. "I've looked for anything that would have caused that 20-basis-point jump and can't find anything. If those expectations come unglued, that would cause the Fed to panic." To be sure, a market-based expectation can also turn out to be completely wrong and, on its own, "doesn't become a self-fulfilling prophecy," he said. "No one knows what the world is going to be like in 10 years, so it's just a best guess and one piece of the puzzle."The problem facing the Federal Reserve is that Americans can feel the stress of inflation even when it's drifting lower, as reflected in a recent Census Bureau survey. The central bank operates with a 2% inflation target.As long as other surveys of inflation expectations such as the New York Fed's remain stable, policymakers can be "cautiously comfortable with where breakevens are trading" for now, Compernolle said. The next major U.S. inflation update arrives in the form of the consumer-price index for October, which is set to be released next Tuesday. On Wednesday, the 10-year Treasury yield BX:TMUBMUSD10Y finished at its lowest level since September after a $40 billion government auction, while major U.S. stock indexes DJIA SPX COMP ended mostly higher.

-Vivien Lou Chen

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11-08-23 1606ET

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