Inflation expectations and Treasury yields
Source: Federal Reserve Bank of St. Louis, as of December 10, 2020. The breakeven inflation rate is a market-based measure of expected inflation over a set period of time. It is derived by calculating the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
- Pricing pressures have been almost entirely absent for much of the past decade as both major measures of inflation, the Consumer Price Index and Personal Consumption Expenditures Price Index, have remained stubbornly below the Fed’s 2% target. The COVID-19 pandemic exaggerated the conditions that had already been in place, as inflation readings plummeted in Q2.
- Looking forward, the Fed continues to discount rising prices as a near-term threat. In its September economic projections, the FOMC estimated that inflation won’t rise to 2% again until 2023.1
- Market-based signs of inflation, however, finally began to show signs of life in recent months. As the chart shows, both the 5- and 10-year breakeven inflation rates, which measure expected inflation over the respective timeframes, have fully rebounded from their March lows and just moved above pre-pandemic levels, having gotten a jolt from positive vaccine news.2
- Further economic renormalization in 2021, coupled with pent-up demand and more accommodative Fed policy, have the potential to continue nudging inflation expectations higher, making it a valid consideration for investors once again in 2021.
- This is important because over time, long-term rates align with inflation expectations. Thus far this year, the 10-year U.S. Treasury yield has lagged inflation expectations considerably. This opens the possibility that Treasury yields could re-test levels well above 1% again in 2021, leaving higher-duration investments vulnerable to a significant price declines.