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What does the bond market know about inflation?


Inflation is everywhere. Chinese manufacturing prices, broad commodity prices and consumer prices on goods ranging from fruit to freezers are climbing. Everywhere, that is, except in the bond market.

Five-year inflation breakevens—the difference between an ordinary five-year Treasury yield and an inflation-protected one—are around where they were three months ago. They have actually declined in the past month, when discussion of inflation has been most frenzied.

Nor are they particularly high by historical standards. At around 2.47% a year over the next five years, the inflation currently priced into the bond market is above its historical level for most of the low-inflation period following the 2008 financial crisis. But from 2004-2007, which was hardly a period of booming inflation, that level was entirely normal.

Analysts at Nordea note that bond yields are far out of step with their general relationship with inflation over the past 3½ decades. Core consumer price inflation of 3.8%, the level reported Thursday, has never been recorded in the post-1985 period alongside a 10-year bond yield of less than 6%. That indicates a fairly overwhelming belief on the part of investors that inflation is transitory.

How good is the bond market at predicting inflation? Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, suggests that yields are far more closely correlated with past inflation than future inflation, though much of the data used predates the existence of inflation-protected bonds.

But even with that in mind, investors are making a significant bet, since the bonds would slump in value if anything like a normal historical relationship between inflation and yields resumed. Much is made of the Fed’s activity in the Treasury market, but the central bank only holds around 25% of the total. Most is in the hands of investors who stand to lose money in a selloff.

Other forecasts are a mixed bag. The Philadelphia Federal Reserve’s latest survey of professional forecasters, published in May, sees headline inflation at 2.4% on average over the next five years and 2.3% on average over the next 10 years, very much in line with the market pricing. This week the University of Chicago Booth School of Business also released a survey of economic experts on the risk of overheating and inflation, indicating a rough balance between views that the economy is going to overheat and that it isn’t, but with many expressing uncertainty rather than a strong position.

Even if signals from the bond market are imperfect, investors predicting a damaging level of inflation are still clearly in the small minority in the market. What is priced in is, as it stands, almost precisely what the Federal Reserve is looking for. If 1970s-style inflation really is in the cards, those who failed to position their portfolios appropriately can at least take comfort from the knowledge that few of their peers did either.

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