Contrasted Expectations

The US bond market has stabilized over the last two weeks around 1.70% for a 10-year treasury note after the significant rise in long-term yields triggered by Joe Biden’s victory. Market-based inflation expectations have stopped climbing, in contrast with the message sent by businesses and consumers alike in the recent surveys.

Just as we explored the information content of businesses inflation expectations a few weeks ago, this time we turned our gaze to households. The latest Michigan survey suggests that consumers’ inflation expectations for the next 5 years have rebounded to their long-term average for the first time since 2014. We suspect this can be explained by the recent public debate around the risks of “overheating” the Biden emergency stimulus could trigger. The frequency of queries on the Internet reflects the emergence of an “inflation anxiety” in the US.  These phenomena tend to be self-fulfilling. We show that in a simple model, the Michigan survey, alongside the unemployment rate, is a good predictor of actual core consumer prices.  With the two variables pushing in the same direction now, and business survey continuing to reflect a rise in price pressure, an acceleration in core inflation is very plausible in the coming months, beyond the expected base effects. This will raise questions on the credibility of the Fed’s Average Inflation Targeting framework, pushing real rates up.

This is one of the key elements which make us believe the current stabilization in US yields is merely a pause and we continue to expect the 10-year rate to hit 2% in the coming months. The market is probably taking stock of the risks of yet another wave of Covid before collective immunity is reached, despite the speed of the US vaccination programme. The prospect of tax hikes funding at least partly the newly unveiled investment plan by the US administration may also curb market enthusiasm for Biden’s fiscal activism. But even if the Democrats have their way on this – and contrary to the consensus view until last week, it seems the Senate could use the “reconciliation process” more than once during a fiscal year, reducing the need for bi-partisan support – the tax hikes would be back-loaded, and the supply of US treasuries would rise significantly anyway. True, by year end the US economy may face a complicated moment when the emergency stimulus fades and the mechanical effect of the post-pandemic reopening is absorbed, because the investment plan is unlikely to provide the same impetus. Yet, in the months ahead, the coincidence of higher inflation and higher debt issuance still creates some space for another curve steepening.