By Gavekal Capital Blog
5-year, 5-year forward breakeven inflation has historically been in a range between 2% and 3%. However, over the past year, future inflation expectations have fallen below 2% for the first time since the financial crisis and have bounce around between 1.40% and 2%. Inflation expectations have increased by 35 bps since the beginning of July. It seems, however, that inflation expectations have either accelerated too quickly or that rate hike expectations haven't accelerated enough over the past several months.
In the four charts below, we show the tight relationship between inflation expectations and Fed Funds futures (we take 100 minus the Fed funds futures rate to derive an interest rate for Fed Funds futures). The market is currently pricing in a 50 bps Fed funds rate in December 2016 (i.e., one rate hike) and a 79 bps Fed Funds rate in December 2017 (i.e., one rate hike in 2017). Both of these expectations are well below what Fed funds futures were pricing in a year ago when 5-year, 5-year forward breakeven inflation expectations plunged through 2%. Back then, expectations were for a Fed Funds rate of 100 bps in December 2016 and 160 bps in December 2017. Consequently, the spread between future inflation expectations and the Fed Funds rate expectations hit a new high of 128 bps a week ago for the December 2016 contract. That is 27 bps higher than the average spread between these two series since the December 2016 contract came to market in January 2014. It seems difficult to imagine that the Fed would raise 50 bps by December, and so, we would probably expect to see inflation expectations fall back once again as the rest of 2016 plays out. Or perhaps inflation expectations will continue to increase, which could give the Fed more cover for more hikes in 2017 than are currently priced into the market.