Rising inflation expectations ripple across the markets

Real interest rates and inflation

Source: Bloomberg Finance, L.P., as of March 18, 2021. Long-run inflation expectations are shown as 5Y-5Y forward breakeven rate. Real interest rates reflect the 5Y-5Y forward breakeven rate less the 10-year Treasury yield.

• Long-term Treasury rates continued their sharp rise higher this week as the Fed vowed to keep its accommodative policies in place “for as long as it takes.”¹ On the back of the Fed reaffirming its accommodative stance, the 10-year U.S. Treasury yield soared as high as 11 basis points on the week and is now up approximately 79 basis points year to date.²
• Treasury yields have risen this year along with investors’ expectations for faster economic growth – the Fed significantly upgraded its own expectation for GDP growth this year, from 4.2% in December 2020 to 6.5% in March 2021.¹
• Yet inflation has also become an increasingly prominent part of the interest rate conversation. Market-based measures of inflation expectations have reached multi-year highs as investors fret about the forthcoming impacts of massive fiscal stimulus (most notably in the form of $1,400 checks) combined with monetary stimulus that continues to go full-steam ahead.
• High yield bond returns have been relatively modest but positive (under 1%) in the 3-month stretches when rates rose. But their performance during the subsequent three months has been robust as investors generally tend to focus on the positive macro drivers behind the rate increase.
• Despite the scary headline figures, however, long-term market-based inflation expectations have remained relatively steady at approximately 2% since Q4 2020, as the chart highlights.³ For their part, Fed policymakers project PCE inflation to rise to 2.2% this year before settling down to its 2% target next year.¹
• Said another way, the Fed and market participants both seem to agree that economic conditions will likely improve markedly in 2021 but express little concern that inflation will start raging out of control. Even with inflation relatively contained now, however, rising rates and the mere threat of inflation have already wreaked havoc across duration-sensitive fixed income investments and could continue to make equity markets choppy as investors rotate out of more inflation-sensitive sectors.