Bond Yields, Inflation Near Previous Highs

March 10, 2022

Bond yields edged higher after the Bureau of Labor Statistics reported that inflation in the U.S. accelerated to fresh 40-year highs. According to the BLS, the consumer price index jumped 0.8% in February. Even stripping out food and energy prices, inflation climbed 0.5% in the month. 

On a year-over-year basis, headline and core (ex-food/energy) inflation were up by 7.9% and 6.4%, respectively—the highest level for both indices since 1982. 

 

Headline Vs. Core CPI

 

Though disheartening, some investors took solace in the fact that the numbers weren’t even higher. Most of the readings from the government’s inflation report matched consensus expectations.  

Inflation had largely been expected to peak early this year. As supply chain issues abated, most economists anticipated that the growth in CPI would trend down throughout the year. Those expectations are now being adjusted in light of the recent surge in commodity prices due to the Ukraine-Russia war. 

While supply chain issues may be ameliorating to some extent—especially for key components like semiconductors—new ones may surface in light of all the sanctions and trade disruptions centered around Ukraine and Russia. Neither country is a major exporter of noncommodity goods, so any upward price pressures will probably fuel headline inflation more than core inflation. 

Nevertheless, fearing the prospect of high inflation expectations getting embedded in consumers’ psyches—a phenomenon that could have negative ramifications for actual inflation—the Fed is likely to press forward with its rate hiking campaign with a 25 basis point increase in the federal funds rate later this month.  
 

Treasury Yields 

 

Market-implied expectations of inflation over the next five years hit their highest levels in at least two decades this week. The five-year breakeven rate, which calculates inflation expectations from the difference between nominal Treasury yields and real TIPS yields, topped 3.5%. Prior to November 2021, the breakeven rate hadn’t been above 3% at any point in the last 20 years. 

With the Fed gearing up for its first rate hikes since 2018, bonds have been unable to lend the support to investors’ portfolios that they typically provide in times of economic uncertainty.  

The iShares Core U.S. Aggregate Bond ETF (AGG) is down 4.1% this year; the iShares 7-10 Year Treasury Bond ETF (IEF) is down by 3.2%; the iShares 20+ Year Treasury Bond ETF (TLT) is down by 7.7%; and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is down by 7.9%. 

 

Fixed Income ETF Performance, Year-to-Date

 

It’s unusual for both stocks and bonds to be down in the same year, and that reflects the extremely delicate balance the Fed must strike as it deals with both inflation and risks to economic growth from geopolitical instability. 

The central bank will meet between March 15 and 16 and make its decision on the second day. 

 

Follow Sumit Roy on Twitter@sumitroy2    

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