Despite the confusion surrounding the rate of inflation, Chairman Powell and the FED continues to reiterate their reluctance to raise interest rates. Based on this many fixed-income investors believe nominal rates will remain subdued across the yield curve.
Meanwhile, recent economic data shows the US economy is improving, and a full reopening of the economy can lead to higher inflation during the second half of the year. The above two factors hint of real long-term interest rates remaining negative for a while longer.
Historically, when there is rising inflation coupled with negative real interest rates, equities tend to perform well. Instead, equities tend to struggle when inflation is accelerating, and there are positive real interest rates.
Investors continue to worry about rising inflation will cause bond yields to trend higher. Higher interest rates will force Chairman Powell and the FED to curtail their easy monetary policies causing equities to peak.
The question then becomes - how high would yields have to rise to adversely impact stocks?
Some believe the historical breakpoint occurs when real yields approach the 2% level on the 10-year Treasury. The 2% level has been the inflection point over the last 70-plus years. Since real yields remain negative today, it would imply there may be more room for yields to rise before equities begin to feel the effects of higher real rates.
Contrary to popular beliefs, the 10-year Breakeven Inflation Rate is not a predictor of future inflation. It is a market-based measure of expected inflation in the future. The rate is the difference between the yield of a nominal bond (i.e., 10-year yields) and an inflation-linked bond of the same maturity (10-year). The latest value (2.42 – 5/25/21) implies what market participants expect inflation to be in the next 10 years, on average.
Nonetheless, investors have begun to closely track the 10-year breakeven inflation rate because of the sharp rise from 0.50 at the height of the Covid-19 pandemic (3/19/20) to 2.54 during 5/10/21, 5/12/21, and again on 5/17/21.
The enclosed chart of the 10-year Breakeven Inflation Rate from the Federal Reserve dating back to 2002 shows that this has been one of the sharpest accelerations in the past 13-years. The last time we witnessed a similar jump of this magnitude was during the 2008-2010 timeframe. The 10-year Breakeven Inflation Rate rallied from a low of 0.14 to a high of 2.38.
It is also important to point out that the Breakeven Rate tends to peak at 2.64-2.74. For instance, during 5/24/04 (at 2.74), 3/21/05 (2.73), 5/15/06 (2.68), 4/14/11 (2.62), and 9/14/12 (2.64).
Did the 10-year Breakeven Inflation Rate peak this month at 2.54?
And if this is a peak, does this confirm Chairman Powell and the FED's call that inflation is transitory?