The Reality Of Distorted ‘Expectations’

Is the inflation narrative about to lose traction?

That’s a subject I broached (or, more colloquially, a question I asked) last weekend, after breakevens posted their largest weekly decline since September.

While breakevens may have (very recently) come off the boil, the narrative du jour is that between supply chain disruptions, various “bottlenecks” (a term that’s become a clichéd catch-all already) and labor market imbalances, realized inflation could run hot for longer than the Fed thinks. With the media feeding the story to the masses, it’s possible an inflationary psychology sets in. CPI and PCE prints for April suggested it’s not “all base effects” and consumer surveys show concerns about higher prices are, at the margins anyway, chipping away at sentiment.

With that as the backdrop, Deutsche Bank’s Aleksandar Kocic set about disentangling breakevens into inflation expectations and inflation risk premium in his latest note. Drawing on Fed research, Kocic produced the decompositions shown in the figures (below).

Three things stick out immediately. First, expected inflation has been falling steadily for two decades. Second, post-financial crisis, risk premium tightly hug breakevens (figure on the right). Third, risk premium has done a lot of the heavy lifting in the pandemic era, especially lately.

“Expected inflation is exogenous to monetary policy — a function of the business cycle and transmission of growth to price level with Fed (in the past) even going against the grain as a way of preventing inflation [from] tak[ing] root,” Kocic wrote, distinguishing expectations from inflation risk premium, which “is endogenous to monetary policy, captur[ing] relative uncertainty between what the Fed is (not) doing in the near-term and what consequences that (in)action will have for the long-term policy decisions.”

Kocic noted that prior to 2008, stable calendar spreads were a reflection of policy credibility as “an active Fed in the near-term was meant to guarantee lower long-term uncertainties keeping both short- and long-term vol in sync.”

Post-2008, calendars were closely coordinated with inflation risk premium. “Short-term certainty about Fed inaction causes crowding in certain positions, but as that position grows, the market becomes increasingly more vulnerable to policy unwind,” Kocic wrote. “The vol differential between short and long-term Fed uncertainty becomes the expression of this dichotomy across horizons, while rates articulate that through inflation risk premium.”

The figure, below, illustrates the endogenous character of inflation risk premium and Fed policy.

The inflation risk premium appears to be a function of Fed purchases.

Earlier this year, Sirio Aramonte and Fernando Avalos, writing for the BIS’s quarterly review, found that although inflation expectations “have increased substantially” since the pandemic plunge, “the measured inflation risk premium has also contributed materially.” They attribute that contribution partly to “the funding policy of the US Treasury and its interaction” with Fed asset purchases.

“If you’re buying every risky asset in sight because you think Treasurys are screaming that inflation is finally coming back, beware,” Bloomberg’s Edward Bolingbroke said, around the same time the BIS research was released. “You might be acting on a false signal triggered by the Fed’s massive presence in the bond market.”

That signal may be even more “false” now than it was a few months back.

The BIS noted that a simple, “textbook” explanation of the inflation risk premium “would only reflect the compensation that investors demand for holding nominal Treasurys, over and above the compensation for expected inflation.”

But we don’t live in a textbook (no matter how many times Larry Summers suggests we do). Right now, Aramonte and Avalos said, “the measured inflation risk premium” in the US reflects “imbalances between the demand for and supply of Treasurys and TIPS [and] the relative liquidity of the underlying markets.”

“The Fed has prevented real rates from rising through their purchases and forced breakevens to widen with that maneuver,” one analyst said Saturday. “The Fed has been widening breakevens with their actions,” the same person remarked. “Desks are having to deal with the conjecture that this is not the doings of fiscal policy.”

So, what happens next? Well, while elaborating on the interplay between supply, Fed buying and retail investor interest in hedging the inflation that’s shown up in rising commodity prices (for example), Bloomberg Intelligence described any efforts to “accurately gauge the pricing distortions these demand dynamics are having” as “impossible.”

The same piece noted that TIPS distortions aside, inflation readings are “undeniably high,” but Ira Jersey, BI’s chief US rates strategist, conceded that market inflation expectations could be skewed by “much more than a few basis points.” That assessment came with the obvious corollary: If the Fed trims its TIPS buying, it “could be followed by a rise in real yields and a decline in inflation breakevens.”

In a separate piece, dated March 24, Deutsche Bank’s Stuart Sparks expanded on the link with raw materials, noting that “rising reserve balances in effect ‘devalue’ dollars versus commodities,” another example of breakeven widening being endogenous to the Fed’s asset purchases.

A key implication is that in order for breakevens to keep rising, the Fed has to keep expanding the balance sheet. The only way around that is if the current policy conjuncture manages to engineer higher services inflation.

“This was the reason that fiscal policy was necessary to improve the Fed’s chance at raising inflation expectations – they need to run the economy at a large positive output gap, harnessing the Phillips curve relationship to push wages (and hence services inflation) higher,” Sparks said, in the same note.

That assumes pricing power, though, something Sparks readily acknowledges. If that assumption doesn’t hold (i.e., the cost of higher wages can’t be passed along to consumers in the form of higher services costs), margins compress, with negative implications for the recovery. “The key investment conclusion is once again that absent a sustained increase in wage growth and significant pricing power, the point of inflection for breakevens should be the end of balance sheet expansion,” he remarked.

For his part, Deutsche’s Kocic wrote that if the Fed is, in fact, driving the inflation premium wider via asset purchases leading to wider calendars, a taper announcement should reverse those dynamics. “The asymmetric bid for long dated vol would taper and the short dated vol would begin to rise as short-term action enters the play with the upper left corner of the surface outperforming,” he said. “At that point, a possible rise in inflation would proceed through higher expectations driven largely by the effects of fiscal policy.”