One major theme this year, as the American and global economies reopen, is the risk of rising prices. The yield on the 10-year Treasury increased from 0.91% at the start of the year to a high of 1.74% on March 31. But over the past month, that yield has moved back down and is likely to return toward 1.45% in the near term.
So why the retreat, and what does it mean?
In our estimation, this decline in yield most likely represents a rethinking by market participants and investors about the risk of rising inflation to the economic outlook.
While we expect inflation to move above 3% this year, we anticipate a return back toward 2% next year. It would appear that the disruption to global supply chains is now seen as transitory, so as those supply chains return to potential capacity this year and next, that pricing pressure will abate.
One can observe that dynamic in our preferred forward-looking metric of pricing pressures, the Federal Reserve’s five-year, five-year forward inflation expectation rate. It now stands at 2.39%, which is below this year’s peak of 2.63% posted on March 19 and well below the 20-year average of 4%.
This continues to point not to inflation, hyperinflation or dollar debasement. Rather, it points toward long-term price stability and an anchoring of inflation expectations. In addition, it strongly implies that the disruptions to supply chains caused by the pandemic, no matter how inconvenient, are not in the process of changing how inflation expectations are formed.
Because the actual inflation rate is determined by expected inflations, this strongly suggests that the Federal Reserve will be successful in achieving its policy goals, and that the robust recovery of the economy will proceed without significant damage to the production sector or American households.
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