The US Breakeven Curve Is, Well, Broken

Authored by Ven Ram, Bloomberg cross-asset strategist,

Fixed-income traders may be considerably underestimating how long price pressures will persist in the developed economies.

The breakeven curve in the US has gone from being inverted six months ago to pretty flat now. The change in the slope of the line isn’t as much a surprise as is the level of the points on the curvature: to the extent a central bank tightens policy and restores market confidence that it is acting decisively on inflation, the curve would “normalize”.

However, what is intriguing — as the chart shows — is that the curve has shifted considerably lower at the front and intermediate segments. That strikes me as premature. Take, for instance, the two-year breakeven rate, which is now around 2.05%. The Fed’s own projections show that it will miss its PCE inflation target right through 2025. Yes, it’s possible that we get an economic downturn well before that, but the current pricing strikes one as being completely lopsided in favor of that proposition.

Yes, sometimes true price discovery in breakevens can be marred by poor liquidity.

But the message isn’t a whole lot different when you look at forward-starting inflation swaps. The 5y5y swap rate is now around 2.68%. That shows the markets are basically dismissing an inflation problem in our midst considering that we are right around the average going back nearly two decades.

If there is one thing that has consistently surprised the markets in this cycle, it is that inflation is a lot stickier than we imagined it to be, and there is no point mistaking a tail risk for a central scenario.

If the Fed was accused of sticking to the transitory mantra for too long early in the current cycle, now perhaps it’s the markets that are embracing it late in the cycle.