Inflation slowdown is no mystery to the bond market

(Bloomberg View) - The Federal Reserve and other central banks have been on a quest since 2012 to get inflation back up to levels they deem appropriate for a stable, growing economy. There have been many setbacks along the way, leaving central bankers stumped, with Fed Chair Janet Yellen saying the slowdown in inflation has been a "mystery." But their crusade may now be looking a bit less quixotic, judging by recent moves in the bond market.

Although inflation looks sluggish, there's evidence that pressures are building beneath the surface. This is can be seen in energy prices, general consumer prices in China and the U.K, and even in the New York Federal Reserve's Underlying Inflation Gauge, which has risen to 2.7 percent, its highest reading since 2007. The UIG incorporates dozens of additional variables outside of prices, including the unemployment rate, stock prices, bond yields and purchasing managers' indexes, according to Bloomberg News.

At her news conference last week, Yellen dismissed the importance of trend inflation as measured by the UIG because the overall "inflation miss" remains unexplained. More than 25 percent of the components that make up the Consumer Price Index are in a protracted deflationary trend. But the U.S. economy may soon see a period of reflation simply because the prolonged bout of inflation "misses" could lead to more instances where the data registers higher readings as it's being measured against a lower base.

Markets certainly appreciate the potential that inflation misses have to boost the prospects of faster inflation down the road, just like what happened after energy prices bottomed in early 2016. Back then, the CPI went from an average of about 1 percent in the first half of the year to as high as 2.7 percent this past February. Even though deflationary pressures may continue to weigh on the CPI due to global value chain and technological advancements, history shows that reflationary trends are a recurring phenomenon.

Bond markets have begun to anticipate at least some reflation in a more meaningful way. Long-term real yields have fallen on average by 40 basis points since the start of the year, driven by flows into inflation-linked bond ETFs from investors seeking protection from higher consumer prices. At the short-end of the Treasury Inflation-Protected Securities curve, break-even rates have been rising since July on the expectation that rebuilding efforts in the aftermath of Hurricanes Harvey and Irma, along with higher oil and gasoline prices, will at least led to higher headline inflation. And the market for inflation derivatives, such as inflation swaps with a zero percent floor, is pricing a very low probability of deflation. That sentiment is also reflected in the University of Michigan consumer sentiment survey, where respondents' expectations of flat to lower prices has fallen to the lowest since 1990s.

Deflation Expectations

Source: Bloomberg, Michigan Survey

Even though reflation may be stirring, global TIPS still have an average break-even rate of just 1.75 percent, which is well below the global average inflation rate of around 3.7 percent. That doesn't mean inflation is as stable as once thought. In fact, volatility in inflation and break-even rates has been higher than before the financial crisis, on average. Inflation has become less predictable from period to period as a result of the deflationary trends in the CPI. Markets should be rooting for some reflation, which has shown to be beneficial to higher-risk assets such as equities.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ben Emons is chief economist and head of credit portfolio management at Intellectus Partners LLC. The opinions expressed are his own.