Five-year inflation expectations are the rate at which the citizens, including the investors, businesses, and consumers, expect the costs to increase in the future. They matter because the actual inflation depends on what we expect it to be. Suppose everyone thinks the prices will rise by two percent over the next year. In that case, firms will want to increase the prices by at least two percent, and unions and workers will wish similar raises for themselves. All else equal, if five-year inflation expectations increase by a single percentage point, the actual inflation will tend to increase by a single percentage point as well. The expectations of bond traders for how fast inflation will increase over the coming five years have gone beyond three percent for the first time in history.

An increase in the so-called breakeven rate on Treasury Inflation-Protected Securities shows that the investors are looking for protection for the consumer-price gains beyond the Federal Reserve's 2%-overtime target. The rate increased by more than nine basis points to more than three percent a few days ago. It reached the maximum level on record in data that goes back nearly twenty years ago. This followed an increase where buying overwhelmed the supply. This was very surprising because it occurred even as the government auctioned a record $18 billion of five-year TIPS. Investors purchase TIPS as the Federal Reserve allows inflation to run high while the economy recovers from the coronavirus. The US Treasury yields are also climbing. The demand for inflation-protected bonds and notes has kept those yields relatively stable.

The difference in yield between Treasury yields and TIPS represents the inflation rate required to equalize their returns. Less than a basis point of the growth in the 5- year breakeven rate is attributable to the 5-year TIPS auction. According to reputed strategists, it became the benchmark issue, replacing the one that started in April. The short-maturity Treasury yields touched the top levels since the beginning of the coronavirus outbreak as inflation concerns drove traders to factor in a couple of US interest-rate increases by the end of the following year. The interest-rate hikes are not going to happen anytime soon. But central bankers will act if the inflation expectations become unexpected. This was said by Loretta Mester, the Cleveland Federal Reserve President. As for the central bank's asset purchases, Federal Reserve Chairman Jerome Powell said that tapering would start soon and conclude by the middle of next year.

TD Securities strategist Priya Misra said that while the five-year breakeven rate has increased, the 5-year forward inflation swap rate, which is a market-based inflation forecast that surpasses the present rampage in commodities, remains below the May year-to-date high. She said, "There is a growing realization that supply-chain disruptions may last much longer than what anyone thought. The pandemic has disrupted logistics, transportation and jammed up global ports. In contrast, a labor shortage and the recent energy crisis have worsened things. The move in the breakeven rate also reflects the risk that if inflation is due to supply-chain disruptions, even a Fed rate hike won't help lower it,” she added. ”That's what the Fed is likely watching to see if inflation expectations are getting unanchored. If a longer-dated move occurs, that "could actually force the Fed's hand." 

Investors are focused on five-year inflation expectations

Investors and traders are focusing on inflation pressures as the meetings of the Federal Reserve go on. This is because of the probability that incoming inflation readings will be higher for the next few months. The consumer price index has grown by 5% or more on a year-on-year basis for five consecutive months. But the seasonal adjustments to the data of September may have made the yearly pace of 5.4% appear a little lower than what would be the case otherwise. Jay Hatfield, portfolio manager and founder at Infrastructure Capital Advisors in New York, said that his company sees a fifty-fifty probability of a recession in the next year. He thinks there will be high single-digit percentage changes in CPI reading throughout the following year.

Rob Daly is the director at Glenmede Investment Management in Philadelphia. He states that he is looking at the possibility that inflation will be durable but not punitive. After releasing the five-year inflation expectations, the top US stock indexes were consolidating after increasing earlier this week. The S&P 500 SPX traded above its record closing level for a brief while. The Nasdaq Composite Index traded higher by 0.3%. Dow industrials decreased by 0.4% or more than 100 points. 

Bond Market Says Inflation Will Last

Almost everyone, including stock market investors, homeowners with huge heating bills, renters, and buyers of used cars, has been fretting about the increasing prices lately. But despite several of the fastest price growth in decades, the investors in the treasury bond market who are attuned to inflation have been steady in their belief that it was only a temporary condition. But that is changing now. A key measure of five-year inflation expectations of the bond market is breakeven. It increased to a new high, going over three percent for a little while. This means that investors expect inflation to stay at the three percent level for a year for the following five years. This is much higher than any time in the decade before the start of the pandemic.

The Producer Price Index and the Consumer Price Index reading for a couple of months ago were released recently. The latter showed that the prices grew more than five percent from the previous year, and slightly faster than before. But experts say that the main concern for investors in the bond market was that the prices unrelated to the coronavirus pandemic have also started increasing for lengthy stretches once they begin to move upwards. The rents have increased 0.5 percent from August to September. This is the fastest rise in about two decades. The energy prices also rose more than twenty percent in the previous month. This is driven by massive growth in fuel oil and gasoline costs. The increasing crude oil costs are behind the increase, and there is little sign that these pressures will go away anytime soon. The crude oil costs are continuing their onward surge. They have increased more than twelve percent in October and over sixty percent for the year.

John Briggs, a strategist at NatWest Markets in Stamford, Connecticut, said, "The market saw this as evidence that the pickup in inflation will not be as transitory as the Fed had hoped." Steven Friedman, a senior macroeconomist at MacKay Shields, was a market analyst at the Federal Reserve Bank. He said, "They put great stock in inflation expectations. How investors position themselves influences how Fed policymakers think because those putting forward their opinions have skin in the game."

Conclusion

The measures of inflation expectations over more extended periods, such as over the coming decade, also increased to multiyear highs. The expectations of the bond investors are essential. This is because officials at the Federal Reserve, who are assigned to manage inflation, see the signals from the bond market to decide when to increase the interest rates. The more excellent rates put the brakes on inflation. But they can also slow hiring and ding the stock prices. The Federal Reserve Chairman and other central bank officials have spent many months saying that the higher inflation was a transitory result of the pandemic-driven supply chain issues. There have been great reasons to believe that the increase in prices could be a more significant concern.