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The Chart That Terrifies The Fed
Zero Hedge
For many months, the Fed had openly ignored what the market was signaling about future inflation expectations, either through 5Y,5Y forwards or breakevens, instead opting to rely on such trivial and unreliable indicators as inflation surveys and beige book narratives. However, with the collapse in 10 Year yields back under 2% that has now changed. Here is what yesterday’s FOMC minutes had to say on this topic:
A couple of participants remarked on the apparent disparity between market-based measures of expected future U.S. short-term interest rates and projections for short-term rates based on surveys or based on the median of federal funds rate projections in the SEP. One participant noted that very low term premiums in market-based measures might explain at least some portion of this gap. Another possibility was that market-based measures might be assigning considerable weight to less favorable outcomes for the U.S. economy in which the federal funds rate would remain low for quite some time or fall back to very low levels in the future…
In other words, the Fed is suddenly at odds with what not only the market, but the Fed’s favorite market-driven indicator of future inflation expectations is saying.
Does this lead the Fed to believe that it may be wrong? That remains to be seen but here is a take from BofA in its daily chart of the day:
[Recently] we argued that the drop in inflation breakevens adds another downside risk to inflation. Thus far, Fed officials have dismissed the dramatic drop. They note that surveys don’t show the same drop, and they argue that the drop may be technical. We are less sanguine. Looking at the current market, let’s take the extreme assumption that the inflation risk premia has dropped to zero — that is, investors are so certain about inflation that there is no insurance value in breakeven contracts. If the liquidity premium hasn’t changed, then current breakevens are consistent with 1.8% expected PCE inflation. In other words, either the market believes that even five years from now, the Fed will not achieve its target or the liquidity premia has jumped to 30bp.
