Source: Zhitong Finance Author: Yu Jing

Federal Reserve Chairman Powell is paying more attention to protecting the job market, which has encouraged a large number of bond traders to bet that inflation will continue to rise.

Tim Magnusson, chief investment officer at Garda Capital Partners, said, “Powell basically supports going long and break-even.” He refers to a trading strategy where profits from inflation-linked securities exceed those of ordinary bonds.

At last week's press conference, Powell emphasized for the first time in the current cycle that an unexpected rise in unemployment may prompt officials to lower interest rates. The latest forecast released by Federal Reserve policymakers on March 20 also shows that inflation and growth are expected to accelerate in 2024, while retaining the forecast of three interest rate cuts in the so-called bitmap.

“I'm guessing they're willing to tolerate inflation slightly higher than we expected,” Magnusson said.

Magnusson isn't the only one doing it. Bank of America strategists led by Mark Cabana suggested betting on a 30-year break-even bet on Wednesday. “At the same time as a relaxed financial environment, stronger growth expectations, and greater upward risk of inflation, the Federal Reserve is guiding interest rate cuts, which means higher compensation for inflation.”

A break-even market indicates that inflation expectations have been rising. The 5-year break-even interest rate (measuring the difference in yield between ordinary 5-year bonds and inflation-protected bonds) is currently around 2.43%, far below the peak of about 3.76% in early 2022, but about 40 basis points higher than the low in December last year.

After Federal Reserve Governor Waller said on Wednesday that they are not in a hurry to cut interest rates, swap traders slightly cut their bets that the Federal Reserve will cut interest rates as early as June on Thursday. According to the current contract, the implied probability of interest rate cuts in June is about 60%.

Speaking at the New York Economic Club on Wednesday, Waller stressed that recent economic data is a reason to postpone or reduce the number of cuts this year.

A further rise in break-even interest rates may encourage bets on a steeper yield curve. Many investors are betting that longer-term US Treasury bonds will not perform well as the Federal Reserve cuts interest rates and the inflation rate hovers above pre-COVID-19 levels. This will restore the typical premium of 10-year Treasury yields over 2-year Treasury yields.

Survey-based inflation expectations, and market-based inflation expectations, which Federal Reserve policymakers are closely watching, also show that consumer prices are rising faster than recently. According to a recent survey by the University of Michigan, consumers expect an average growth rate of 2.9% over the next 5 to 10 years. This is up from 2.2% before the pandemic.

Federal Reserve policymakers' own median predictions show that their favored personal consumer spending price index (PCE) will exceed the 2% target this year and next. They raised their forecast for this year to 2.6%, which excludes highly volatile food and energy costs, from 2.4% in December last year.

Powell said last week that “the higher year-end data reflects the data we have seen so far this year,” including price increases in January and February that were faster than expected. He said, “Despite this, we are still looking for data that can confirm last year's low readings, which gives us more confidence.” Inflation continues to move towards 2%.

This Friday, the latest personal consumer spending price report is expected to show a core monthly increase of 0.3%, but it is still not in line with the Federal Reserve's target.

Macro research firm Jim Bianco said that it is risky for the Federal Reserve to cut interest rates while inflation is still high. “If they're not careful, they might cut interest rates, and if the bond market doesn't think they're serious about inflation, we may see higher yields rather than lower yields.”

Gang Hu, managing partner of Winshore Capital Partners, said Powell's information last week on balancing inflation risks and protecting the labor market meant that it might take longer for the inflation rate to fall to 2%.

“The Federal Reserve's response function has changed,” Hu said. “Compared with inflation, the Federal Reserve is more concerned about the unemployment rate. The break-even ratio is more likely to rise than fall.”

edit/lambor