BofA sees inflation markets as Fed credibility measure

Investing.com -- Bank of America analysts said Friday that forward inflation measures now serve as the primary indicator of Federal Reserve credibility following recent comments from Fed leadership about market-driven policy tightening.

The bank pointed to remarks this week from a Fed official suggesting that markets are now helping determine the appropriate policy stance. According to BofA, the official indicated that the rise in real yields has already delivered meaningful tightening, reducing the urgency for immediate Fed action.

BofA said this framework creates a challenge for rates markets and complicates the typical curve reaction to incoming data. The bank questioned what mechanism forces accountability if inflation surprises to the upside and real yields rise because investors expect a Fed response, but the Fed ultimately does not deliver.

The bank said the answer lies in forward inflation measures, with the Fed placing special weight on 5-year, 5-year forward breakeven inflation measures. BofA said this metric limits oil price impact and provides the best read on longer-run market-based inflation despite liquidity issues.

BofA noted that 5-year, 5-year forward breakevens have remained relatively low since March despite clear upside risks to spot inflation, reflecting confidence that the Fed would ultimately deliver sufficient tightening. The bank said the sharp increase in these measures following the recent Fed press conference suggests that confidence is lower as investors question whether the Fed will match its inflation rhetoric with policy action.

The bank said 5-year, 5-year forward breakevens remain broadly consistent with historical ranges and are not yet sending a full-blown warning signal. BofA recommended going long 5-year, 5-year forward inflation swap at 2.39% targeting 2.65% with a stop of 2.25%.

BofA said its base case remains that the Fed begins hiking in September. The bank identified a large equity selloff and hawkish Fed action as risks to the trade.

You May Also Be Interested In

• U.S. debt tops $40 trillion
• Silo Pharma acquires software assets from Parkview Consulting for stock
• FOMC minutes from July 28-29th meeting