The intense battle between the Federal Reserve and high inflation has been going on for two years, but bond investors are now seeing a new risk: the possibility of excessive slowdown in US price increases.

Just a day before the release of the August CPI report in the US, an indicator measuring future CPI growth expectations showed that the US inflation rate may be below the Federal Reserve's target for a long time. The so-called 10-year breakeven inflation rate fell to 2.02% on Tuesday, the lowest closing level since 2021.

This breakeven inflation rate is calculated based on the difference between the benchmark 10-year US Treasury yield and the yield on 10-year inflation-protected securities (TIPS). Currently, the nominal US Treasury yield is declining faster than TIPS, leading to a decline in the breakeven inflation rate.

Strategists also note that some technical factors are at play, including the low liquidity of US inflation-protected bonds and the sharp drop in oil prices. However, they warn that the breakeven inflation rate does indicate concerns about the perceived slowness of the Federal Reserve's monetary policy easing.

For a long time, the Federal Reserve has believed that a sustained decline in inflation is as harmful to the economy as a significant increase in prices, as it would force policymakers to keep interest rates too low in the long term, weakening their ability to resist new economic recession risks.

For a long time, the Federal Reserve has believed that a sustained decline in inflation is as harmful to the economy as a significant increase in prices, as it would force policymakers to keep interest rates too low in the long term, weakening their ability to resist new economic recession risks.

SGH Macro Advisors chief US economist Tim Duy said that market participants are currently recognizing that the momentum of high inflation in the United States has completely ended. Now, as the balance of risks shifts to the employment task, the Fed's efforts to curb inflation may be excessive, and now "this risk must be taken very seriously."

Inflation is facing a low risk.

With signs of cooling inflation and labor market, it has cemented expectations that the Fed will cut interest rates for the first time since 2020 next week. US Treasury yields have been rebounding since the end of April. The 10-year US Treasury yield touched 3.64% on Tuesday, the lowest since June 2023, while Brent crude oil fell below $70 per barrel.

Currently, the biggest debate focus in the market is how fast the Fed should lower the benchmark interest rate to protect the economy. The current federal funds rate target range is still at a high level of 5.25%-5.5%. Data from the interest rate swap market shows that traders have fully priced in a rate cut by the Fed at the September 18 meeting, and believe that there is over a 20% chance of a large 50 basis point cut.

At Beijing time tonight, the US Department of Labor will release the latest CPI data for August, which will also be the last set of key economic indicators before the Fed's September interest rate meeting. The industry generally expects that the year-on-year growth rate of CPI for the month will slow significantly to 2.5%, well below July's 2.9% and the peak of 9.1% in June 2022.

In addition to the longer-term inflation outlook, Angelo Manolatos, a strategist at Wells Fargo Securities, said that inflation swap contracts show that the short-term inflation outlook in the United States is becoming more severe.

One-year swap contracts show that traders are betting that US CPI will only rise by about 1.7% in the next 12 months, indicating a significant slowdown.

Manolatos pointed out, "These trends indicate that the US bond market is pricing in a high risk of a hard landing. Another insight is that even though we only saw CPI reach 9% a few years ago, there is clearly not much inflation risk premium now."

It is also possible that the bond market is wrong.

Of course, it should be pointed out that the above indicators that reflect inflation expectations in the bond market are not foolproof. In the past two years, the bond market has been proven wrong multiple times because they were too optimistic that inflation would slow down rapidly after the epidemic.

Some strategists are also skeptical that the recent decline in the breakeven inflation rate has been too large and too fast. Barclays Capital strategist Michael Pond advises clients to position themselves for a steeper breakeven curve in the forward market and suggests that investors underestimate long-term inflation risks.

Crédit Industriel et Commercial, led by strategist Subadra Rajappa, also advised clients last week to bet on a rise in the five-year breakeven inflation rate.

In a report, Rajappa wrote that even in the case of an economic recession, it is rare for the average inflation rate of CPI to fall below 2% within five years. Since 1945, this has only happened 24% of the time.

She added that due to the Fed's focus on "low" prices, it is attractive to "buy inflation protection" at low levels.

Editor/Somer