One interesting feature of the recent price action is that despite the high conviction among investors that central bankers will act – that is clearly evident in the price of safe assets – market-based expectations for long-term inflation such as the 5-year/5-year forward (5y5yf) breakeven have not budged. Instead, they remain marooned at rock-bottom levels. Breakevens often move in sympathy with risk assets, but not this time Market signals that inflation will not be consistent with policy targets in the future
In truth, the behaviour of breakeven inflation rates is a puzzle. Alongside the optimism over imminent policy action, the news on the conduct of monetary policy in the medium term has also been broadly positive.
The US Federal Reserve continues to make gradual progress towards a modest change in its framework that should deliver a higher inflation rate on average in the future. The risk of a hawkish appointment to replace Mario Draghi as ECB president did not ultimately materialise. Nor are measures of underlying inflationary pressure in Europe or the US obviously moving in the wrong direction. A pragmatist would have expected a bounce given the rally in risk assets because breakevens often move in sympathy with risk assets.
The behaviour of breakevens presents something of a puzzle for policymakers too. Market prices suggest that the market is beyond questioning the credibility of the monetary policy framework and is outright challenging the idea that inflation will be consistent with policy targets in the future.
In years gone by, policymakers might have been prompted into more decisive action in an attempt to restore credibility. However, the lower breakevens go, the more central bankers may conclude that the signal-to-noise ratio in these market-based measures of inflation expectations is very low, and hence there is less need to act in response.
This article is an extract from BNP Paribas Asset Management’s fixed income outlook
Investments in the aforementioned fund are subject to market fluctuation and risks inherent in investing in securities. The value of investments and the revenue they generate can increase or decrease and it is possible that investors will not recover their initial investment. Source: BNP Paribas Asset Management Holding.