Stop Looking for Fed Errors in the Bond Market

Past dislocations suggested deflation was on the horizon, but it never came to pass.

Deflation will be averted.

Photographer: Scott Olson

The decline in oil and energy prices in recent weeks has had a big impact on the market for Treasury Inflation-Protected Securities. After all, who needs a hedge against faster inflation if the evidence shows that it’s slowing? The reaction was so severe that some TIPS began to price in a risk of deflation not seen since the financial crisis, causing a rare inversion at the very short-end of the TIPS curve.  

The fallout wasn’t just limited to TIPS, as the yield curve for nominal Treasuries flattened to the point where prices reflected a much slower pace of interest-rate increases than projected by the Federal Reserve. Such moves can become a self-fulfilling prophecy that undermines Fed policy if central bank officials believe that the market is really worried about the risk of deflation. That’s why there’s been no shortage of pundits saying that the Fed’s decision two weeks ago to boost rates amounted to a “policy error.”

Recall that in 2008 there was a similar dislocation in the TIPS market, but the dire outlook for inflation expectations reflected in yields at the time never came to pass. In fact, research by the Fed found that TIPS have a liquidity risk premium that during times of distress can reach 200 basis points. Other Fed research has found that despite the occasional “shock” to break-even rates, which are essentially the difference between inflation-protected and nominal Treasury yields and represent the rate of inflation that traders expect over the life of the securities, the probability of actual deflation remains low.

TIPS Liquidity Risk

TIPS maturing in January 2018 and July 2018 are shown on the left-side axis. The TIPS maturing in July and April 2013 are shown on the right-side axis.

Source: Bloomberg

It’s therefore not hard to see how a dislocation in the TIPS market and a sharp drop in break-even rates can paint a very different picture than what is actually happening in the economy. Just take a look at the recent trend in real, or inflation-adjusted, yields, which tell a different story. The longer end of the TIPS curve has seen a decline in real yields since the start of the year as the Fed increased rates two times.

But if traders thought rate hikes would lead to deflation then real yields would have risen, too. Rather, the recent flattening of the TIPS and Treasury curves has been more a function of the search for yield and income, driven by a regulatory environment that incentivizes demand for longer-maturity “safe” assets. A look at the derivatives market shows that the premium on inflation swaps with a zero percent inflation floor has remained very low, and the inflation swap market considers future deflation risks to have diminished.

 Real Yields and Inflation Swaps

Source: Bloomberg

The Federal Reserve Bank of Atlanta has a model that calculates the probability of deflation implied from the price of TIPS by analyzing changes in coupon and cash flows of the most recent and seasoned securities. Since 2010, the probability for deflation in the next five years has consistently fallen and is flat in the latest reading. The TIPS market doesn’t seem worried about deflation, and the recent moves may just be a reflection of seasonality trends due to the effect of declining energy prices.  

Federal Reserve Atlanta Deflation Probabilities

Source: Atlanta Federal Reserve

In late 2008, the distortion in break-even rates impacted expectations for long-term real interest rates. Since then, however, inflation and rate expectations have been on a secular decline because of the low-inflation environment. Federal Reserve Bank of Chicago President Charles Evans expressed in a recent speech that inflation running below the central bank’s target of 2 percent for consecutive eight years was a serious “policy outcome miss.” In his view, the Fed should adopt a more flexible policy that ensures the target is not a ceiling.

For the moment, financial markets are pricing inflation below target for the next 10 years and put the long-term neutral real rate at 1 percent. A policy error, therefore, may have already occurred after the financial crisis when inflation expectations became distorted. To correct that mistake, the Fed is actually following a tightening policy that also allows inflation to accelerate above the target. The recent June rate hike may not necessarily have been such a mistake but rather an opportunity for reflation to return.

Source: Bloomberg

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