US inflation expectations scale highs for year

Several widely-watched gauges of US inflation expectations have climbed to their highest levels this year, as oil prices regain their footing and some investors bet that the Federal Reserve will be slow in quelling any price pressures.

The US 10-year "breakeven" rate measures the market's expectations of average inflation over that time by comparing the yields of conventional US Treasuries maturing in 10 years and Treasury Inflation Protected Securities, or Tips.

The 10-year breakeven has shot up from a low of 1.53 per cent in mid-January to 1.92 per cent on Monday, the highest since November 2014. The five-year breakeven rate has risen to 1.71 per cent, the highest since September, while the two-year is at its highest since July 2014.

"It's a big move," says Luca Paolini, chief strategist at Pictet Asset Management. "It follows from core inflation picking up, which no one seems to be talking about."

Break-evens are an imperfect gauge of inflation expectations, given that some Tips trade irregularly, but concerns over subdued inflation or even deflation have eased as crude oil prices have stabilised and begun climbing lately. Falling energy prices was the biggest factor dragging down the US inflation rate down below zero earlier this year.

However, the "core" inflation rate, which strips out energy and food prices, unexpectedly ticked back up to 1.8 per cent in March, and many economists expect wage growth to pick up further in the coming year as the US labour market becomes tighter.

As a result, some investors are reappraising the outlook for prices and shifting some of their bets on interest rate policy. Ahead of the US central bank meeting on Wednesday, daily deposits into global inflation-protected bond funds monitored by EPFR Global indicate that inflows have hit a weekly record, with US funds dominating investor interest.

Up until April 22, roughly $1.4bn has flowed into US inflation-protected bond funds - more than the previous three months combined.

The Fed's own measure of long-term expectations - the so-called five-year, five-year forward rate, or the average five-year inflation rate implied by swaps in five years' time - remains modest at 1.94 per cent last Wednesday.

Mr Paolini does not expect a big inflation spike, but cautioned that bond markets - currently trading at record low yields - are unprepared for even the risk of somewhat less subdued inflation, which could spur the Federal Reserve to become less dovish.

"The market's not positioned for this," he said. "If we see inflation pick up further, then the expectation that the Fed won't hike even until 2016 will look too optimistic."

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