Actual and expected inflation are diverging.
Over the last couple of years, the idea of inflation expectations in the US remaining “anchored” have been a cornerstone of the Federal Reserve’s reticence to raise interest rates.
Low rates, at heart, are really about pulling demand forward to engineer economic growth.
Amid flagging economic growth and tepid inflation readings, market expectations for future inflation have plunged.
And given that the Fed is targeting 2% inflation, a decline in inflation expectations is a concern for the Fed as lower expected inflation gives consumers less incentive to spend money now instead of save it.
In recent months, however, inflation has shown signs that it is not dead. Not by a long-shot.
“Core” inflation — which excludes the price of food and gas — as measured by the consumer price index, showed prices rising 2.3% year-over-year as of June. The Fed’s preferred measure of inflation, core personal consumption expenditures, is up a more modest 1.6% over the prior year, largely due to the way these two price measures weight the cost of shelter.
But it’s clear that after years of complacency in markets around inflation — and particularly in the wake of Fed Chair Janet Yellen’s great 2014 call to ignore higher inflation — a divergence is growing in markets that could spell trouble down the line.
And as core CPI continues to move up, a bond market that continues to bet on lower growth, lower inflation, and lower rates appears particularly vulnerable, according to analysts at Goldman Sachs.
A Goldman research team, led by Robert Boroujerdi, wrote in a note to clients out Tuesday that they estimate investors in US bonds could lose 7% between now and year-end if the 10-year Treasury moved back to its 12-month high of 2.3%.
On Wednesday morning, the US 10-year was trading near 1.52%. Risks of big losses are even higher in Europe, where yields are significantly lower than Treasurys and even, in many cases, negative.
Goldman writes that this potential loss is “not priced in and perhaps that is why inflation expectations, nay deflation expectations, run so rampant in investor conversations. To be clear, this is illustrative and while our readers may question the potential for this phenomenon to occur, forget 2016 and think about some degree of mean reversion over the next 5 years.”
In other words, everyone is betting that bond yields at record lows will remain at record lows and have no impetus to run higher. And maybe they shouldn’t.
A report from Bloomberg’s Brian Chappatta out Tuesday showed that for the first time this year, the year-end 10-year Treasury forecast fell below the current yield, indicating that to some extent the market has already begun surprising investors, if only slightly.
Additionally, inflation readings from the US indicate that this outright complacency is perhaps not warranted.
Economic growth may be running below 2% right now, but as we saw last Friday wage growth continues to hit cycle highs. More money in the pockets of consumers portends higher consumer prices down the line.
And as dynamics in the housing market, namely increasing rents and a lack of supply on the low end of the market, continue to set up for higher prices, the bond market — and financial markets more broadly — could be in for an unpleasant surprise.