In several of the blog posts this year, we have been discussing our view that the rate of change for inflation will likely decline in 2022 compared to 2021 despite the increase in energy and other related commodities (here, here, here). Our view was based on the combination of more difficult comparisons for consumer prices (both commodities and other components) and economic data (a headwind for demand) as well as the lack of corroboration from market-based inflation signals and expectations.
The recent move higher in commodities has caused near-term market gauges for inflation to increase, but longer-term measures have been more stable. These divergencies highlight that the current market view is that either commodities normalize as geopolitical tensions ease or sustained higher prices lead to weaker economic activity. Either way, inflation levels will likely not remain at current levels on a long run basis.
The recent February Consumer Price Index (CPI) reported a 7.9% annual increase, the highest since 1982. The market impact was most apparent in shorter-term measures of inflation. The expectation for the one-month overnight index swaps (OIS) one year from now moved to the highest level this cycle, ending the week at 2.11%.
Source: Bloomberg.
The futures market is pricing in between 6-7 25bps increases in the Federal Funds Rate, the most this cycle.
Source: Bloomberg.
Short-term interests responded to these changes, with two-year U.S. Treasuries increasing from 1.48% on Friday the 4th to 1.74% on Friday the 11th, a new cycle high.
Source: Koyfin.
Shorter-term measures of inflation also increased. Five-year inflation swaps and breakeven rates increased, and two-year breakeven rates increased by an even larger amount.
Source: Bloomberg.
Source: Macrobond.
Shorter-term inflation expectations also increased. The University of Michigan consumer survey reported one-year expectations of 5.4% (also the highest level since 1982 but below the just reported 7.9% CPI).
While these shorter-term measures of inflation increased, the longer-term measures are not responding in the same manner. The expectations for one-month OIS two years from now increased to 1.96% and the spread between the one-year and the two-year rate widened to -20bps. The three-year measure was unchanged at 1.76% and the spread between the three-year and the one-year rate widened to -30bps.
Source: Bloomberg.
The Eurodollar curve (another market measure for future short-term interest rates) responded in a similar fashion. The near-term measures for 2022 increased during the week to new cycle highs, while the outer year measures became more inverted.
Source: Bloomberg.
The 10-year U.S. Treasury increased from 1.74% on Friday the 4th to 2% on Friday the 11th but did not make a new cycle high. The 30-year U.S. Treasury increased during the week but is also not at a new high.
Source: Koyfin.
This divergence in new highs has led to flatter interest rate curves across multiple measures.
Source: Koyfin.
10-year inflation swaps and breakeven rates did not increase to the same degree as two- and five-year rates. This has led to a record gap between shorter- and longer-term inflation measures.
Source: Bloomberg.
Source: Macrobond.
The University of Michigan survey showed a similar pattern as the five-year expectations remained at 3% and are within the same range they have been since 2008.
Source: Macrobond.
These market moves suggest that investors are increasingly expecting the rate of change for economic growth and inflation to slow in 2022 and that increases in short-term interest rates will quickly be reversed.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC