The bond market's new bet on interest rates
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Financial markets increasingly have a new bet about the next phase of America's economy: Inflation may be coming under control, but borrowing costs could stay higher for longer.
Why it matters: The de-escalation in the Iran war and the reopening of oil flows have caused a marked improvement in the near-term inflation outlook, but that hasn't translated into cheaper overall borrowing costs.
- Rather, bond prices are indicating higher real interest rates, counteracting the decline in market-based inflation expectations.
- It means that the energy price retracement has brought little relief to rate-sensitive sectors. Mortgage rates have bounced around near 6.6% in recent weeks, for example, well above the 6% rate in late February before the attack on Iran.
The big picture: For much of 2023 and 2024, cooling inflation was widely expected to coincide with a slowing economy and Federal Reserve rate cuts, meaning overall interest rates fell in tandem. Now, the improvement on the energy price outlook is running headlong into massive global demand for capital.
- That appears to be driven by companies investing in the AI buildout. Tuesday morning, for example, reports emerged that Amazon is planning a $25 billion bond sale.
- Another factor: Governments worldwide are running massive deficits and may borrow further to invest in a defense buildout.
- It also comes as the Fed, under new chairman Kevin Warsh, looks to reassert its credibility as an inflation fighter.
By the numbers: Treasury bond prices now imply annual inflation of 2.3% over the next five years, based on the spread between inflation-protected securities and regular Treasury notes — a steep drop from the most recent peak of 2.7% in May, near the height of the oil price surge.
- Longer-run inflation expectations have also cooled, with the 10-year breakeven falling to about 2.2% from an early June peak of 2.4%.
- "Inflation risks have come down," Warsh said last week.
Yes, but: Real yields — the return investors demand on top of expected inflation — are moving in the opposite direction.
- Since early May, five-year real yields have jumped to 1.9% from 1.3%, while 10-year real yields have climbed to 2.2% from 1.9% — leaving both near their highest level of the year.
- The rise in real yields has offset the retreat in inflation expectations, keeping benchmark Treasury yields around 4.5% despite the sharp decline in the bond market's inflation outlook.
What they're saying: "One way to think about it is that inflation expectations are pricing in Fed credibility," says Aditya Bhave, head of U.S. economics at Bank of America.
- Bhave says markets are expressing greater confidence in the Fed's commitment to fighting inflation, citing Warsh's blunt statement last month that the Fed will deliver price stability.
Zoom in: At the same time, falling energy prices are lowering inflation while removing what many investors feared would become a meaningful drag on consumer spending.
- "'How long can the consumer hold on?' That's the question we were getting two months ago," Bhave notes. "That question is moot now, so if you're thinking that activity is going to be stronger going forward, then that could also support real yields."
What to watch: Bhave also points to a broader structural shift. Stronger productivity, corporate efficiency and a more deregulatory policy environment could allow the economy to sustain faster growth without reigniting inflation.
- If businesses see more productive opportunities to invest, demand for capital would remain strong, a dynamic that tends to keep real interest rates elevated.
