Has the Bond Market Gone Crazy?

Signals from the bond market show what some investors consider a remarkably optimistic inflation outlook. As shown in the chart below, next year’s Treasury-market-implied inflation rate was 3.5%, as of the market close on Aug. 10. In the following year, this rate fell to 2.7%, and by year five to 2.3%, close to the Federal Reserve’s long-standing 2% inflation target.

Bond-market skeptics may find this interpretation hard to swallow. Even though July’s consumer price index showed a decline in year-over-year headline inflation, the core CPI (excluding food and energy) was unchanged and, at 5.9%, is still exceptionally high by historical measures. Skeptics will point to highly expansionary monetary and fiscal policy, combined with increases in commodity prices induced by the Ukraine war and supply-chain bottlenecks, as causes of this inflation and may argue it is likely to persist, as consumers and businesses revise their inflation expectations and demand higher wages and prices.

Revisiting our macroeconomic scenarios

The skeptics may yet be shown to be right, but market-implied inflation signals are still important as investors consider future economic scenarios. In April, we looked at three scenarios for U.S. inflation and Fed policy based on assumptions of macroeconomic shocks and Fed-policy strength and credibility. We called these scenarios “Soft landing,” “Slamming the brakes” and “Stagflation.”

If current market-implied inflation expectations turn out to be approximately accurate, the inflation part of the soft landing will in fact have been realized. Talk of stagflation will have been shown to be premature and erroneous. But lower inflation expectations could also be aligned with the “Slamming the brakes” scenario, where Fed rate hikes prove to be overaggressive and trigger a hard landing and prolonged economic downturn.

Investors may want to scrutinize more carefully the implications to their portfolios resulting from either the “Soft landing” or “Slamming the brakes” scenarios.