Goldman Sachs Group Inc. and bond titan Pacific Investment Management Co. have a simple message for Treasuries traders fretting over inflation: Relax.
The firms estimate that bond traders who are pricing in annual inflation approaching 3% over the next handful of years are overstating the pressures bubbling up as the U.S. economy rebounds from the pandemic.
Add to that certain technical distortions in the way market-based inflation expectations are priced, and Goldman Sachs, for one, says the overshoot could be as large as 0.2-to-0.3 percentage point. That gap makes a difference with key market proxies of inflation expectations for the coming few years surging earlier this week to the highest in more than a decade. Those measures fell on Friday after weak U.S. jobs data.
There’s at least one market metric that backs up the view that the pressures, which have been building for months, aren’t about to get out of hand and may even prove temporary. A swaps instrument that reflects the annual inflation rate for the second half of the next decade has been relatively stable in recent months.
The debate over inflation is crucial as policy makers and investors navigate the recovery from the pandemic. The Federal Reserve has been hammering home that it sees any spike in price pressures as likely short-lived, and that it’s willing to let inflation run above target for a period as the economy revives.
Now it appears to be catching a break with its campaign. Not only are the likes of Goldman and Pimco laying out the case for a more benign inflation outlook, but traders have also trimmed bets on rate hikes by the end of 2023. The market stepped back even further from those tightening wagers after Friday’s report showing much smaller-than-forecast April job gains.
“We do not see the sort of inflationary pressures that markets appear to be fearing, and high growth rates will not necessarily translate into a higher inflation rate,” said Praveen Korapaty, Goldman’s chief interest-rate strategist.
Market measures known as breakeven rates, which are derived in part from Treasury Inflation-Protected Securities and represent expectations for annual increases in consumer prices, surged anew in the first half of this week as the reopening of major industrial economies progressed.
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Inflation worries have been mounting against a backdrop of soaring commodities prices—copper, for example, set a record high Friday. It’s all happening as lawmakers in Washington debate another massive fiscal-stimulus package.
But it’s worth noting that two-year breakevens—which reached an almost 13-year high close to 2.9% on Wednesday—are firmly above where traders see inflation expectations in the second half of the coming decade. That shows the market is positioned for price pressures to eventually ebb.
Korapaty calls the outlook for inflation “benign.” His view is that the market is overly optimistic with its inflation assumptions, with the greatest mismatch to be found on the three- and five-year horizon. At roughly 2.75% and 2.65%, respectively, those rates are around 20 to 30 basis points higher than they should be, in his estimate.