Inflation Alarms Fade After Dollar Rally Provides Fed Cushion

  • Ten-year U.S. breakeven rate declines for fourth straight day
  • Dollar index has climbed to the highest level since 2002

Long-end inflation markets show the outlook for gains in U.S. consumer prices is diminishing after the Federal Reserve’s hawkish turn this week propelled the dollar even higher.

The Fed’s guidance of three rate increases next year has added to disinflationary pressures as the dollar’s surge may weaken U.S. export growth and weigh on imported inflation. A disinflationary impact may also come from devaluation of China’s renminbi via capital outflows.

The tentative reversal in the inflation outlook, after the reflation witnessed following Donald Trump’s presidential victory, is also reflected in the options market. The premium on bets that consumer price increases will reach 2.5 percent in two years has edged lower to 44 basis points. The year-to-date high was 48 basis points on Dec. 12, which matched the highest level touched during the "taper tantrum" of 2013.

Financial conditions have tightened as borne out by a stronger currency and increase in long-end rates with risks the U.S. Treasury will increase issuance to support Trump’s fiscal stimulus plans augurs well for the rise in inflation-adjusted rates.

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