Inflation expectations are heating up, but investors might want to stop panicking if they knew how the sausage was made.
Rising market-based inflation forecasts, or breakeven rates, are widely quoted as Wall Street’s go-to indicator of where consumer prices are headed. And they’ve been pointing higher amid widely shared hopes for more fiscal relief and vaccine distribution.
But analysts say the key shortcoming of breakeven rates as an indicator of future price pressures is that they’re derived from U.S. Treasury inflation-protected securities, a notoriously illiquid product that can be nudged around by the ebbs and flows of investors around the market.
“Breakevens are probably the last metric I’d look at for inflation expectations,” said Steve Feiss, managing director of fixed income at Etico Partners. “Wall Street is too quick to move to the conclusion that the Fed is winning and inflation is coming.”
The 10-year breakeven rate stood at 2.16%, around its highest level in over two years, suggesting investors anticipated consumer prices to average above the Fed’s inflation target over the next decade.
But some say the Federal Reserve’s asset purchases are having an outsized effect on the market, inadvertently lifting market-based inflation indicators.
The central bank now owns 23.4% of the entire TIPs market, up from the 10% share before the pandemic, according to data from Blomberg.
Last year, the Fed accelerated its pace of asset purchases to support the recovery and keep bond markets functioning after they gummed up last March.
Joseph Gagnon of the Peterson Institute for International Economic noted many of the central bank’s purchases of TIPs were concentrated in the 5-year area, where the inflation-indexed yield had plunged and thus pushed breakeven rates higher.
He argues that might explain why short-term breakeven rates were more elevated than their longer-term peers, and reflected how the combination of illiquidity and a powerful buyer could distort perceptions around inflation.