US Bond Market Flouting Inflation Looks Increasingly Vulnerable

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A sharp decline in yields over the past two months is mainly due to falling inflation expectations. That means that so-called real yields, which are protected from inflation, have declined less than their nominal counterparts. Their lagging performance reflects shrinking demand for protection against rising prices.

The broader bond market is also signaling that a Federal Reserve policy rate peak short of 5% will be enough to cause a recession, requiring rate cuts totaling half a point during the second half of the year. Some argue there’s no longer much margin for error. A pick up in demand for this week’s auction of 10-year inflation-protected Treasury notes suggests investors are beginning to listen.

“For months now people have had the conviction that inflation is behind us and so there’s been a big rush into bonds,” said Ben Emons, senior portfolio manager at NewEdge Wealth. If China reopening causes an inflation pop or a recession doesn’t materialize, it’s going to be a problem.

The relative yields of real and nominal Treasuries reveal the expected average rates of increase for consumer prices over the term of the notes. For 10-year notes, they reached the lowest level of the past year this week, 2.09%. The five-year breakeven inflation rate dropped to 2.13%, within a basis point of last year’s low.

“In bonds our kryptonite is inflation,” said Jack McIntyre, portfolio manager at Brandywine. “Our thesis is that peak inflation is in the rear view mirror and we suspect by mid-year or later there will be evidence the economy is really weakening and inflation is melting. A lot of tightening is still set to hit the economy at a time when it is already slowing. At this point I don’t see a reason to be bearish on bonds.” —Bloomberg