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Here's why the bond market is really scared about Fed policy

Key Points
  • The bond market's fear about Fed policy is showing up in a spread that indicates falling expectations for inflation, which is also a concern at the Fed as it could signal low growth or even a recession.
  • The market is watching the key spread that implies consumer inflation could run at a low average of 1.37% over the next five years.
  • In the bond market, that means Fed policy is too tight and the Fed needs to cut rates to generate inflation.
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As the rest of the world slows, the U.S. economy has shown weakness but no big cracks. But one area that has been raising alarms, and one that can sway the Fed, is the market's expectation that inflation will go lower and stay there for a very long time.

Bond market expectations for inflation have been falling.

The widely watched spread between 5-year Treasury yields and the yield on 5-year Treasury Inflation-Protected Securities is at about 1.37. This spread is a measure of inflation compensation in the Treasury market over the next five years, including expected inflation and a risk premium.

"Over the next five years, it implies CPI would be 1.37% and it implies that inflation is moving away from the Fed's 2% target," said John Briggs, head of strategy at NatWest Markets. CPI was running at 1.8% year over year in July.

The spread was at about 1.5 on Aug. 1, but it last slumped to a very low level in 2016, hitting 0.85 when oil prices were falling.

"It's one of my arguments why they should be cutting. ... Inflation expectations are signaling the Fed is going to miss its mandate over a long time," said Briggs.

When inflation expectations slump, the market does not have a clear answer for what it means, but traders say it could indicate a coming recession, a lower growth trend, or just the fact that pricing structures have changed, with such forces in retail as Amazon and other online outlets.

"It indicates that even if we have tariffs, it will be difficult to pass that on to the consumer in terms of higher consumer prices, which leads to profit compression," said Jon Hill, rate strategist at BMO.

Fed officials have been focused on low inflation, but the minutes from the last Fed meeting show they disagree on whether low rates of inflation are transitory. The Fed is also discussing moving from a targeted 2% inflation target to a symmetric target — or more of a range, on either side of 2%, though there is disagreement on that as well.

Inflation expectations have been worrying the bond market, just as the bond market's inverted yield curve signal has been a scary recession warning for the stock market.

"I''d say that's [inflation] been a core focus. The other is looking abroad," Hill said, noting the slowdown in economic data has largely been in other countries. "You have $16 trillion of negative-yielding debt around the world, none of it in the U.S., and it's giving investors pause as they consider whether it's possible in the U.S."