Falling U.S. inflation markets may signal further market volatility

By Karen Brettell

(Reuters) - Falling inflation expectations in U.S. bond markets are flashing warning signs that markets may stay volatile, and adding to fears about the slowing global economy.

Inflation-linked markets have been pricing in increasing doubts that inflation will recover, which is a worry as they have been one of the first markets in recent years to anticipate slowing growth.

“In the last year or two, inflation break-evens were well ahead of the market in terms of looking at the global growth problems that we’ve been having,” said Aaron Kohli, an interest rate strategist at BMO Capital Markets in New York.

Expectations of what five-year inflation will be in five years based on Consumer Price Index swaps fell to 1.81 percent on Tuesday, the lowest in at least 10 years.

Inflation expectations based on Treasury Inflation-Protected Securities (TIPS) are also trading at the lowest levels since 2009. Deterioration in these bonds in the second halves of 2014 and 2015 foresaw weakness in global demand, while other market indicators were slower to react, said Kohli.

Market inflation projections have moved further apart from the Fed’s own view this year, which has added to uncertainty and increased market volatility.

“The Fed is basing their policy on the fact that they believe the decline in oil will have a transitory effect on inflation, while many investors are coming to the conclusion that the drop in oil is more permanent,” said Brian Reynolds, chief market strategist at New Albion Partners.

“The split between investors and the Fed, and the split between analysts and traders in the oil market, are responsible for a lot of the volatility that’s going on in the markets,” he said.

Testimony on Wednesday by Fed Chair Janet Yellen will be watched for any signs that the Fed may be rethinking its view. The Fed has maintained that the impact of falling oil prices will pass, and maintained a long-term inflation target of 2 percent.

Traders are not the only ones who are worried. A gauge of U.S. inflation tumbled last month to its lowest level since the Federal Reserve Bank of New York began the survey in mid-2013.

“We think the Fed should be more concerned about this drop in inflation expectations, which is broad-based across a number of indicators,” said Michael Pond, global head of inflation-linked research at Barclays in New York.

(This version of the story corrects firm name in seventh paragraph to New Albion Partners, not Albion Partners)

(Reporting by Karen Brettell in New York; Editing by Matthew Lewis)

---

Serious News for Serious Traders! Try StreetInsider.com Premium Free!

---

You May Also Be Interested In

• At least 13 Tunisians missing after migrant boat sinks off Tunisia, group says
• Judge narrows Ben & Jerry's lawsuit accusing Unilever of silencing social activism
• Explainer-What we know about the door handles that triggered China’s record auto recall