The Federal Open Market Committee unleashed a sharp change in market expectations following its Wednesday meeting, helping to curtail inflation fears. The idea of the first rate hike being pulled forward into 2023 with a possibility of 2022 elicited a change in the inflation trade and a resetting of market expectations of inflation. While the initial knee-jerk reaction in the market was to send the 10-year yield higher—it closed the day at 1.57%—that yield has gone round trip and is trading near 1.48% at this writing after dipping as low as 1.46% in the overnight trading session on Friday morning.
Perhaps more importantly, the shape of the entire yield curve is resetting with a flatter slope as the spread between the 30-year less 5-year yield stands at 111 basis points, down from 156 basis points as recently as May 13. This strongly implies that investors are pulling back on expectations of inflation remaining sticky and are beginning to price in a more benign inflation outlook, in line with the Fed’s forecast of a transitory or temporary increase in inflation this year and next that ultimately falls back toward the intertemporal target of 2%.
How can we test that interpretation? Let’s look at the Fed’s five year, five year forward which has declined to 2.17%, well below the long term average of 4% and just above the central bank’s 2% inflation target. From our point of view, this indicates that forward-looking investors are signaling to both buyers and sellers in financial markets—as well as the broader policymaking community—that the risks to the economic outlook linked to inflation are overblown. Moreover, what we are witnessing in near real time is a function of the Fed’s credibility on establishing price stability over the medium to long term.
We expect the Fed to begin talking more explicitly about the tapering of its asset purchases at the Kansas City Fed Symposium at Jackson Hole, Wyoming, in late August and to formally include a road map on what that looks like in its September FOMC policy communique.