Bond Market Shows U.S. Is Leading in Race to Reflate the Economy

The U.S. is emerging as an early favorite in the all-out showdown to rekindle inflation in the world’s major economies.

With the Federal Reserve planning to hold interest rates near zero until at least 2023 and Congress working on another fiscal boost, a pocket of the debt market is starting to see consumer prices modestly over 2% in years to come. That’s in stark contrast to Europe where deflation fears have reawakened, and Japan, which has battled moribund price pressures for decades to no avail.

It’s early days, of course, and investors are still quibbling over whether the Fed will succeed in spurring price gains. But they’re ramping up bets that its new inflation policy, aggressive bond buying and its slate of liquidity programs will help the U.S. reflate its economy more convincingly than in other developed nations. With many central banks backed into a corner with ultra-loose monetary policy even before the crisis, the U.S. has quickly out-eased its peers, squelching criticism — from the president, among others — of earlier rate hikes and widening the gap between price expectations in the U.S. and euro area to a decade high.

“The U.S. is reflating, but Europe and Japan are struggling,” said Robin Brooks, chief economist of the Institute of International Finance. It’s “unambiguously” a big deal that the Fed has shifted policy, and “that creates headaches for the ECB and the Bank of Japan, who are both facing a challenging inflation picture,” he said, during a Bloomberg TOPLive blog.

Moderate price gains are generally seen as a positive for an economy as they encourage consumers to spend now, rather than save for another day.

The Fed has made reviving inflation a cornerstone of its recovery playbook, announcing a new framework last month that would allow prices to exceed its 2% target to offset periods of depressed gains. That policy gained sharper teeth this week when the Fed said it would look to see this level of inflation — as well as full employment — before hiking rates.

Inflation won’t return overnight. A Fed survey of economists shows most see limited price pressures as far out as a decade. And even the central bank itself sees inflation only hitting 2% in 2023, according to its median projection — although at least one committee member thinks it could be as soon as next year.

Investors are clamoring for more detail on how the Fed will encourage inflation, but they’ve already paid attention to the change in tone.

While U.S. breakevens — the difference between nominal rates and those on inflation-linked bonds — remain subdued, a swaps-market measure of five-year price expectations in five years time has climbed above 2% since the Fed’s policy adjustment. The gauge, which references the consumer-price index rather than the Fed’s preferred PCE price index — is still a long way from the highs it reached after the 2008 financial crisis. But last month it booked its biggest gain since November 2016.

By contrast, headline inflation in the euro area is negative for the first time since 2016. And ECB President Christine Lagarde warned last week that the situation may get worse in the near term, despite the central bank moderately raising its forecast for price gains in 2021. The gap between similar inflation swaps in the U.S. and euro-area hit a decade high in the past week, excluding a brief March spike amid abnormal market conditions.

The Bank of Japan is in a similarly tight spot. The differential between 10-year U.S. breakevens and Japanese equivalents is near the widest in over a year.

“We remain relatively skeptical of European inflation,” said Thomas Walker, investment director at Aberdeen Standard Investments, who has an overweight position in inflation-linked U.S. Treasuries. “There are a multitude of factors at play here, but Europe has been struggling to generate inflation for quite some time now. Even before Covid-19, the ECB has struggled to generate inflation.”

It’s a long-standing dilemma for the euro-area’s policy makers, as well as investors. The ECB is reviewing its inflation target, but flagging price pressures could potentially stymie consumer spending, worsening the economic shock from the coronavirus and cementing fears of Europe’s “Japanification” — a state of near-permanently low inflation and reliance on institutional support.

In the worst case, price declines can become entrenched and spur a slump in wages, in a downward spiral of deflation that has historically wrecked economies.

While some of the reasons for Europe’s troubles are structural — an aging population, for example — others are far more recent, such as the euro’s more than 10% appreciation since a low in March. The currency’s strength is a double-edged sword; on the one hand, it reflects trader optimism in the region’s economic recovery, as well as fading fears of an EU breakup, but it also makes achieving the central bank’s 2% inflation goal a tall order.

When the euro broke above $1.20 this month for the first time since 2018, the central bank’s Chief Economist Philip Lane was quick to talk it down, and Bloomberg Intelligence strategists Huw Worthington and Bhumika Gupta say euro strength raises the threat that prices in the euro area will fall.

“A strong euro can stoke deflationary pressures in the EU,” they wrote in a note. “The currency is working against Lagarde’s inflation target, but options are limited, with QE having little impact on the exchange rate and rate cuts becoming toothless.”

Still, a reduction of 10 basis points or more in the ECB’s deposit rate — already at a record low of minus 0.5% — may prevent euro appreciation fueling deflation fears, they added.

Read more:
  • Strong Euro Gives ECB’s Lagarde a Tough Lesson in Japanification
  • Lagarde Says Euro Gains Blunted Stimulus Boost to Inflation
  • The Great Inflation Debate Is Heating Up With Trillions at Stake
  • BlackRock Joins Crescendo of Inflation Warnings Amid Virus Fight

Christoph Rieger, a strategist at Commerzbank AG, sees investor bets on a further ECB rate cut persisting. Traders in money markets currently expect such a move in the second half of next year.

“Unless inflation starts to rise or the euro starts to tumble on its own, this should keep rate-cut speculation alive,” Rieger wrote in a note to clients. “The genie is out of the bottle.”

— With assistance by Kriti Gupta, and Paul Gordon

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