Traders drove inflation bets to its highest level in more than a decade as fears of rising prices in the US Treasury market increased.
The 10-year break-even inflation rate – a market measure of expected US inflation in a decade – rose to 2.76 percent on Friday, its highest level since 2006. The 5-year break-even rate, which the Inflation rate measures up 3.18 percent in five years, the highest level of data from 2002, according to Bloomberg.
These bets are the latest example of the impact of Wednesday’s blockbuster consumer price index data, which showed U.S. inflation was up 6.2 percent year over year in October. In response to the inflation numbers, government bonds with shorter maturities were sold as investors bet the Federal Reserve will have to hike rates sooner than previously expected.
U.S. inflation has been at 5 percent or more since May as prices have been driven higher by coronavirus-related supply chain disruptions. However, investors were unsettled by signs of widening inflation across multiple sectors, which may weaken support for the Fed’s view that price pressures are “temporary”.
The interest-sensitive yield on the two-year Treasury bond rose by 0.01 percentage points to 0.52 percent on Friday. The return was around 0.42 percent before Wednesday, the strongest increase since the market turmoil in March 2020.
Another closely watched measure of interest rate expectations, the Eurodollar futures, showed that the market is pricing in the first quarter-point rate hike as early as June, with up to two more hikes by the end of next year.
Inflation is depressing the value of government bonds with longer maturities, so expectations of price pressures have risen, and yields on 10-year bonds and 20- and 30-year bonds have risen. The yield on the 10-year benchmark bond rose 0.02 percentage points to 1.57 percent on Friday.
Break-evens are the difference between the yield on inflation-protected Treasury securities – or the so-called real yield – and the yield on a similarly maturing Treasury bond. Since the interest payments for tips are adjusted for inflation, the break-even rate signals how traders and investors predict future inflation developments. The real interest rate is the rate of return freed from the effects of inflation.
While five- and ten-year breakeven inflation rates have risen, real yields on both bonds have declined. The 10-year real interest rate fell to a record low on Wednesday and hovered near that level on Friday. The five-year real yield moved back towards the record lows reached in May. Real yields are moving in line with growth expectations, and this week’s decline suggests that investors believe that the US economy could be hurt if the Fed hikes rates too early.
“What we are seeing are two different parts of the market worrying about two potentially different outcomes. The break-even complex saying – hey inflation is here to stay. Negative real returns imply that there are medium- or long-term growth concerns. And that really gets to the heart of the problem, whether or not the Fed is making a political mistake, ”said Ian Lyngen, Head of US Rate Strategy at BMO Capital Markets.
Meanwhile, Wall Street stocks rose on Friday as investors looked past inflation concerns to focus on strong corporate earnings.
The S&P 500 index closed 0.7 percent and ended the week less than half a percent lower after hitting a series of record highs earlier this month. Sentiment was also lifted by Johnson & Johnson, the world’s largest healthcare company, which announced a spin-off of its consumer business.
Elsewhere, the technology-driven Nasdaq Composite Index was up 1 percent at the time of the bell. Europe’s regional Stoxx 600 closed 0.3 percent.
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