As I’ve pointed out here before, if you want to know where inflation is headed, don’t listen to the talking heads on TV or the internet.
Listen to the bond market. After all, talk is cheap—but money is real.
The yakkers and pundits don’t really know where inflation is going. And their predictions are inevitably skewed by their own personal biases—political and otherwise. Everyone seems to have an ax to grind.
Meanwhile the bond market is betting actual money. Trillions of dollars of it. And its forecasts aren’t perfect, but they aren’t knowably wrong either—because if they were, people could make billions betting against it.
Well, the latest news is that it’s finally happening: The bond market is starting to panic about inflation.
The market’s inflation forecasts have suddenly surged, breaking out this week to a new peak and predicting sustained inflation rates not seen since the 1980s.
That, naturally, follows skyrocketing fuel and other commodity prices in the wake of Russia’s invasion of Ukraine.
It raises the likelihood that Federal Reserve chairman Jerome Powell will raise interest rates more and for longer than previously hoped.
And it poses growing concerns especially for retirees, many of whom are living on fixed or semi-fixed incomes.
The bond market is now predicting average inflation of 3.43% for the next five years, which is a jump of two-thirds of a percentage point just in the last month.
That is twice the 1.7% average inflation rate seen from 2010 to 2020. It’s also well above the averages seen since the 1980s, after Federal Reserve chairman Paul Volcker finally got consumer prices under control.
The bond market’s forecast is known as the “break-even rate” and comes from comparing the market interest rates on two types of U.S. Treasury bonds: Those that have inflation protection, and those that don’t.
Less than a month ago I pointed out here add the link that retirees could once again get guaranteed long-term inflation protection by purchasing 30-year Treasury inflation-protected securities, or TIPS, which were then offering a positive inflation-adjusted interest rate. That brief window of opportunity has now closed. Worry about rocketing consumer prices has caused a stampede into these long-term TIPS, driving up prices and driving down interest rates. (Bonds work like a seesaw: When the price rises, the interest rate or yield falls.) TIPS at all maturities now offer negative real yields: They are, in other words, expensive inflation insurance.
The surge in inflation forecasts follows a 65% jump in the price of crude oil since the start of the year. Putin’s invasion of Ukraine, and Western sanctions against Russian oil and gas exports, have raised the specter of alarming shortages. Fears were not relieved when the leaders of Middle Eastern oil producing countries refused even to take a call from President Biden.
The market fears that the West has few immediate alternative sources of supply. The latest news is alarming, but there are also some more hopeful signs.
That 5-year forecast is less than half the current inflation rate: In other words, while the market fears inflation will be higher for longer than previously expected, it also still thinks the current surge in prices is temporary. It is expecting inflation to come back down, and sharply.
Oil prices fell Wednesday, following a surge that has lasted since the invasion of Ukraine began two weeks ago. And the commodities markets predict oil prices will fall another 20% by the end of the year. (Once again, if you know they’re wrong, don’t tell me about it—go make yourself a trillionaire.)
Meanwhile the stock market also seems to be saying the current oil price spike won’t be sustained. If it’s right that would be very good news indeed on the inflation front.
Since Vladimir Putin launched his shock Ukraine invasion, crude oil prices have jumped by 34%, but the Energy Select Sector SPDR ETF
which invests in an index of oil producing companies such as Exxon
has risen just a third as much.
The reason this matters is that stock markets tend to be forward-looking: Investors who buy and sell stocks need to look past today’s news to next month, next year and longer. If investors thought we were heading back to the 1970s, with high and sustained oil prices, big oil stocks would probably be up much more.
We saw a similar pattern in the spring and summer of 2008, when the stock market correctly predicted a gigantic oil price surge wouldn’t last.
It was a similar story with gold during the boom in 2011, and with timber last year.
What could bring oil back down? A resolution to the crisis. Warmer weather. New supply. Or, even, greater fuel efficiency. Americans currently use twice as much energy per person as people in other rich countries like Germany and Japan, which suggests there is room to save. Simply wasting less energy would be the fastest way to bring supply and demand back into balance.
The bond market’s inflation forecasts could be wrong. Inflation may come in higher or lower than expected. Actually, the bond market’s inflation forecasts change every day, and every time it changes it means it thinks the previous forecast is wrong. But, as I mentioned, if you really think you know the bond market’s forecasts are wrong you can stop reading this, remortgage your home, bet everything you have on leveraged interest rate bets in the options market, and make yourself richer than Jeff Bezos, Elon Musk and Warren Buffett put together.
Let us know how that works out!