“If we are right and inflation readings come off, we might be tempted to fade Fed pricing and take the view that markets can push back when pricing Fed liftoff,” Korapaty said. In addition, he says, that would be the right time to sell three-year breakevens.
New Approach
The discussions around price pressures come amid unease in markets and in Washington over the extent of fiscal stimulus. On Tuesday, Treasury Secretary Janet Yellen stirred markets by saying interest rates will likely rise as government spending swells and the economy achieves faster growth. She walked back the remarks hours later.
The Fed has signaled that it intends to keep policy ultra-loose at least through 2023. In August, it adopted a new approach that lets inflation run above 2% for longer before raising rates. The goal is to get inflation to average 2% over time, to make up for previous shortfalls. The Fed has failed to achieve that level on a consistent basis for much of the past decade.
Granted, some on Wall Street are more concerned about inflation risks. JPMorgan Chase & Co. chief global markets strategist Marko Kolanovic is warning that some money managers face an “inflation shock” to their portfolios.
Futures are now pricing in Fed liftoff around mid-2023, earlier than officials project. Before the disappointing jobs figures, that timeframe was several months earlier. Traders have also reduced wagers on additional hikes by the end of that year. They now see a total of 65 basis points of tightening by the end of 2023, down about a quarter-point since April 1.
TIPS Caveats
Breakevens have long carried the caveat that they can’t be taken at face value because of the illiquidity of TIPS and the risk premium that investors demand due to uncertainty over the path of inflation—both of which lead to higher rates than would otherwise be the case.
Fed officials have developed models to account for those variables, and Pimco has followed up with its own. Its conclusion, in a nutshell, is that inflation expectations are even further below the Fed 2% target than officials assume. That means traders may need to pull back on expectations for Fed liftoff from near zero.
“We basically argued that inflation expectations are a little below where the Fed sees them” after coming in at around 1.75% as of March, the most recent reading in Pimco’s model, said Tiffany Wilding, an economist.
Moreover, she sees the recent rise in five-year, five-year forward breakevens, which strip out short-term noise like fluctuations in oil prices, as partly due to uncertainty around the inflation outlook—as opposed to just an acceleration of expectations.
“Because we think front-end rates are pricing in a more aggressive Fed path than we believe, we do like shorter-dated nominal bonds, and think there’s value there,” she said.
—With assistance from Edward Bolingbroke and Stephen Spratt.
This article was provided by Bloomberg News.