Bond Traders' Inflation Bets Have New Life, Just in Time for Fed

(Bloomberg) -- Bond traders demonstrated this week that for all the doubts about the Trump trade, wagers on quicker inflation still have life. 

Look no further than the U.S. 10-year breakeven rate. It climbed the most on a weekly basis this year, rising back toward 2 percent, suggesting the market is starting to hop back on the inflation bandwagon.

The shift is taking place just in time for the Federal Reserve's May 3 policy announcement. While traders see little chance of a hike this week, an increase is seen as much more likely in June, and is fully priced in by September, futures show. The focus this week may be on Fed officials' assessment of the economic outlook after Trump administration fiscal initiatives that traders were betting on stalled.

“The reflation trade maybe got a little bit over-exuberant, but now it's gotten to the opposite end of the spectrum,” Jonathan Beinner, chief investment officer of global fixed-income strategies at Goldman Sachs Asset Management, said Friday on Bloomberg Television. “Markets are now being complacent as it relates to inflation.”

Breakeven rates are staging a comeback after tumbling to 2017 lows in April, when the core consumer-price index declined for the first time in seven years. Helping trigger the recent leg up, the Fed's preferred gauge of wage growth increased in the first quarter by the most since 2007, data showed Friday. On top of that, euro-area core inflation jumped to the highest since 2013.

Fed Onus

For Goldman Sachs's Beinner, the onus is on the Fed to push the market toward higher rates, given investors' skepticism about the economy and inflation. That means sustaining bets on a June hike, potentially through a signal this week. For the June meeting, using the current effective fed funds rate and the forward OIS rate, the odds are about 63 percent, almost double what they were April 18, when the U.S. 10-year yield touched its 2017 low of 2.16 percent.

Fed officials should be encouraged by the increase in the employment cost index, which shows that having a jobless rate near a 10-year low may be moving the needle on wages.

“We're setting up for a nice rebound” in second-quarter growth, Jeff Rosenberg, chief fixed-income strategist at BlackRock Inc., said on Bloomberg Television. “Into that kind of environment, there could be a bit too much complacency in where yields are.”

Or perhaps they're right where they should be, given the event risk in the week ahead. At about 2.3 percent, the 10-year yield is in the middle of the 2.2 percent to 2.45 percent range that Thomas Roth, head of Treasury trading at MUFG Securities Americas Inc., sees for the weeks ahead.

On Monday, the government releases the central bank's preferred gauge of inflation. At the end of the week, investors get a look at April's payrolls report.

On top of all that, Congress will have this week to agree on a spending bill or risk a shutdown, after passing a stopgap measure Friday.

Here's what else to watch this week:

--With assistance from Jonathan Ferro

To contact the reporter on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net.

To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Mark Tannenbaum