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Inflation Fears Fade Amid Bond Rally, Rise in Rate Cut Bets

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06/11/2019 | 03:41pm EDT

By Daniel Kruger

Investors' expectations for U.S. inflation have declined to their lowest levels since the start of the year, a sign of growing concerns about a slowdown in the global economy.

The 10-year break-even rate, a market-based measure of investors' expectations for the average annual rate of inflation over the next 10 years, has fallen to about 1.7% from nearly 2% in late April.

The decline has coincided with a sharp rise in the odds in the futures market that the Federal Reserve will cut interest rates multiple times this year. That is unusual because it is a sign that the expectation of lower interest rates isn't leading to bets that inflation will quicken. The key reasons why central banks reduce interest rates are to stimulate growth and keep prices stable.

Analysts say the combination is a signal investors have little confidence that the Fed can sustain the inflation rate at its 2% target. Low inflation is good for bond prices because it helps preserve the future purchasing power of fixed coupon and principal payments.

The bond market proxy for future inflation, the 10-year inflation break-even rate, reflects the yield premium on the 10-year U.S. Treasury note over the comparable Treasury inflation-protected security.

The yield on the benchmark 10-year Treasury note settled Tuesday at 2.140%, down from 2.143% Monday. The yield has rebounded this week after falling to a 20-month low Friday, but has declined sharply since hitting multiyear highs late last year amid concerns about slowing growth.

Against that backdrop, investors' bets that the Fed will cut interest rates late this year are merely preventing inflation expectations from declining faster, said Michael Pond, head of inflation-linked strategies at Barclays PLC.

The 10-year yield on Tuesday pared an early climb after the producer-price index, a measure of the prices businesses receive for their goods and services, showed few signs of a pickup in inflation. The measure advanced a seasonally adjusted 0.1% in May from a month earlier, the Labor Department said Tuesday.

Excluding the often-volatile food and energy categories, business prices were up 0.2% from the prior month. Both readings matched expectations of economists surveyed by The Wall Street Journal.

Compared with May 2018, producer prices were up 1.8%, considerably less than the recent peak of up 3.4% reached last summer. Excluding food and energy, the index was up 2.3% from a year earlier.

The WSJ Dollar Index recently declined by less than 0.1% at 90.13. It has fallen about 1.2% from a two-year high in late May. Weak inflation tends to hurt currencies because it removes an impetus for central banks to raise interest rates. Investors typically favor currencies supported by higher rates because they generate higher returns.

Inflation has rarely reached the Fed's 2% target since it was established in 2012. That is a key reason why investors don't think rate cuts would lead to faster inflation. "Any time you get a move up in inflation expectations, it isn't sustained," said Leslie Falconio, a senior fixed-income strategist at UBS Group AG.

Fed officials are concerned about the slow pace of inflation and lower expectations for future price pressures in the economy. One reason is that persistently low inflation could make it more difficult to stimulate the economy when it begins to contract because price pressures, which typically soften when the economy slows, could become even more difficult to address. Another, once expectations for low inflation become embedded, it could also lead to slower growth as well.

Policy makers in Europe, where the European Central Bank has set interest rates below zero and where yields on much of the region's government debt are negative, share this concern. It has been a problem that has complicated efforts by Japanese officials to stimulate their economy, which has faced deflationary pressure for decades.

Fed officials have contributed to doubts about its approach to inflation as they have referred to several instances of weakening price pressure as "transitory." Investors and analysts have said in taking that approach that policy makers are overlooking bigger problems, such as the impact of an aging population and technology, such as automation, which holds down worker wages, and websites such as Amazon that allow consumers to find the lowest prices on consumer goods.

"The market has for quite some time questioned the Fed's ability or willingness to do something" to lift inflation, Mr. Pond said. "It's not clear from here why Fed stimulus would push up inflation,"

Write to Daniel Kruger at Daniel.Kruger@wsj.com

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