Inflation indicators surface while Yellen advocates to ‘act big’ on stimulus

During a historic presidential inauguration week, the financial market spotlight focused on senate hearing testimony from incoming Treasury secretary Janet Yellen. As the former Fed chair fielded questions from lawmakers, she advocated to “act big” on further stimulus, prioritizing relief for today’s economy over U.S. debt burden concerns.

Noting the low interest rate environment, Yellen observed that even though the amount of U.S. debt as a percentage of GDP has risen, the interest burden has not. Amid pushback from the republican side of the senate on the topic, the question remains whether any further stimulus can muster the 60-vote supermajority required for most legislation versus stimulus being embedded in the budget” reconciliation” process, which would only require a simple majority.

Reaction to the stimulus rhetoric shows the market continues to underwrite a full expectation of government intervention in the economy, pushing equity markets to new all-time highs mid-week and supporting long-term rates, which remain comfortably over the 1% level at the 10-year tenor. While remaining elevated compared to post-pandemic levels of 2020, the 10-year treasury also proved volatile, whipsawing between 1.08% and 1.13% multiple times throughout the week. As ever, the looming threat of further proliferation of COVID-19 simultaneously weighed on markets, pushing equities and rates down on Friday as lockdowns intensified in Europe and China.

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As markets price in long-term economic growth in a post-vaccine paradigm, medium term inflation is beginning to manifest itself in the bond market. For the first time in 18 months, the 5-year breakeven inflation rate has exceeded 2%. The breakeven inflation rate is the spread between a nominal U.S. Treasury bond and Treasury Inflation Protected Security (TIPS) of the same tenor; in other words, at the breakeven rate an investor is indifferent between a nominal bond and inflation-protected bond. Put differently, the bond market is pricing in inflation to average 2% over the next five years, which happens to be the Fed’s target for average inflation.

Elevated inflation expectations still come in contrast to the realities of the day-to-day economy, which are not yet inflationary. Retail sales data from last week showed a consecutive monthly decline for December, while unemployment filings went on the rise for the second consecutive week; both signify a sluggishness to the economic recovery. On the bright side, upward trends in housing starts and new building permits indicate a hot housing market, which can portend stronger U.S. consumption data. While the Fed has reiterated its patient stance with respect to future indicators, market participants will keep a close eye on the medium-term inflation outlook and such near-term macroeconomic indicators.

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