The world’s most important market sends a warning

FINANCIAL markets are neither ideological nor do they have an agenda. They’re dispassionate observers, indispensable for helping to discern whether assets are cheap, expensive or fair based on current and historical relative values. So it’s worth taking notice when the US$30 trillion market for US government securities – the one that guides every other and helps set the cost of money worldwide – is sending an alarming message about the outlook for inflation.

For all the criticism the Federal Reserve received for being “behind the curve” in the aftermath of the Covid-19 pandemic, US Treasuries never failed to signal elevated inflation rates would recede under former president Joe Biden. And they did, with the consumer price index falling faster than at any point in modern times, to 2.4 per cent in September from a peak of 9.1 per cent in June 2022.

The bond market essentially validated the assessments of former treasury secretary and Fed chair Janet Yellen and former secretary of commerce Gina Raimondo (highly credentialed economists in their own right) that the abrupt cost-of-living increase in 2021 reflected “a combination of supply and demand shocks, not excessive monetary stimulus”.

“I was on ‘Team Transitory’, which made me much smarter than the majority of my peers in analysing inflation so far this decade,” because the late 1940s, following the Second World War and early 1950s, during the Korean War, “had much more to teach us” about their “impact on prices” than the late 1960s and early 1970s, University of California at Berkeley Economics Professor J Bradford DeLong wrote on Dec 15.

Such confidence disappeared in the bond market this month as evidenced by the two-year breakeven rate – shorthand for what traders expect inflation to average over the following 24 months – which exceeded the 3 per cent rise in January’s consumer price index (CPI). When the breakeven rate is below CPI, traders are in effect betting inflation will slow in the next two years. When it is above CPI, traders are betting inflation will accelerate.

Not since President Donald Trump announced on X that he and First Lady Melania Trump tested positive for Covid-19 in October 2020 has the breakeven rate hovered above the CPI as it does today. Contrast that with the past four years, when the US economy outperformed the world as gross domestic product expanded an average of 3.6 per cent annually and the bond market eschewed any notion that inflation wouldn’t abate.

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Even when it is asserted that such short-term outlooks are nothing more than speculation because the two-year breakeven rate is driven by two-year Treasury notes, the bond market’s longer-dated maturities show an abrupt departure from the sanguineness of 2024. The outlook for inflation during the next decade as measured by 10-year breakeven rates is the highest since March 2023, before the Fed signalled any intention to lower interest rates after the century’s most aggressive tightening of monetary policy. The 30-year breakeven rate similarly is the highest since November 2023 before the Fed decided to ease.

Global investors are becoming all-too-familiar with the unprecedented chaos unleashed during the first month of the second Trump administration, including:

• Impounding of billions of dollars appropriated by Congress to USAID, National Institutes of Health, Department of Education and the Environmental Protection Agency in violation of the Constitution, which authorises Congress to make appropriations.
• Pardons for 1,500 insurrectionists, who assisted Trump in his attempted coup on Jan 6, 2021.
• Disobeying court orders to release federal funds.
• Threats to break treaties with Canada, Denmark, Mexico and Panama.
• Tariffs that raise prices for consumers and reduce manufacturing jobs.
• Hints from Trump that the US might no longer honour its full faith and credit.

If that wasn’t enough to explain the bond market’s unease, consider the University of Michigan’s latest monthly survey of consumer sentiment, which showed Americans expect inflation rates during the next five to 10 years to average 3.3 per cent, the highest since June 2008.

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As for the grocery prices Trump promised on the campaign trail in August to bring down “starting on day one” if he was elected – they, too, are part of the chaos. Eggs in January contributed an additional 1.4 percentage points to food inflation, the most since 2013, according to data compiled by Bloomberg. That’s when our colleague Michael McDonough, Bloomberg’s chief economist for financial products, realised he had to spend 6.1 per cent more for a breakfast of bacon, eggs, cheese and coffee.

And yet, whatever the bond market is saying about what comes next for inflation under this administration, Trump blames Biden.