Inflation Expectations ‘Falling’ — Here’s Why This Could Spark a Rally in Stocks

A cautious U.S. bond market gauge of near-term inflation expectations fell below the Federal Reserve’s 2 percent target for the first time in two years, in a sign that stocks could find some near-term relief after the Nasdaq Composite COMP .
+0.60%
suffered its longest losing streak since 2016 last week.

The drop in the one-year breakeven rate is just the latest sign that “inflation expectations are collapsing,” thanks largely to falling oil prices, according to Jonathan Golub, chief U.S. equity strategist and head of quantitative research at Credit Suisse.

The TIPS/Treasury Breakeven Rate is calculated as the difference between the Treasury yield and the inflation-adjusted Treasury yield.

This easing of inflation expectations should ameliorate the need for the Federal Reserve to continue with aggressive rate hikes, which could be a lifesaver for the market.

“The Fed isn’t trying to control the next inflation print, it’s trying to control what inflation will look like 12 to 18 months into the future,” Golub said during a phone interview with MarketWatch.

“And if the expectation is that inflation is coming down … all else being equal, it means policy doesn’t need to tighten.”

To be sure, the fall in the one-year breakeven rate is not the only encouraging indicator about inflation expectations. A Bloomberg consensus forecast shows economists expect the consumer price index to fall to 2.7% in the fourth quarter of 2023.

Investors will get their next update on inflation expectations on Tuesday when the CPI for August is released. Other recent inflation data was also encouraging, including the Institute of Supply Management’s manufacturing index, which showed that prices paid by U.S. manufacturers fell to the lowest level since June 2020, while prices paid for companies that supply services fell to their lowest level since January 2021.

But while falling oil prices have helped dampen inflation expectations in the near term, there are other obstacles that could give the Fed pause. For example, while short-term indicators of inflation expectations have declined, longer-term indicators have not seen much of a decline, a sign that the costs of housing, education, health care, transportation and other factors that fuel so-called “core” inflation will could be much more difficult to contain.

“THE [one-year] The dead center drop is a little misleading because it largely reflects the effects of the oil. The increasing slope of the breakeven curve suggests that the market is less optimistic about core inflation. In fact, it appears that the market expects CPI inflation to be around 3% after two and three years despite the decline in near-term breakevens. I think these numbers worry the Fed,” Steve Englander, global head of G-10 currency strategy at Standard Chartered, said in emailed comments to MarketWatch.

I see: Will the stock market rally turn into a selloff? This indicator of the bond market could deter investors

While the one-year breakeven inflation rate is just a hair below 2%, the five-year breakeven rate remains at 2.5%, according to data from the St. Louis Fed. This is about 50 basis points lower than its level since June 15.

By comparison, bond yields continued to rise on Thursday, with the yield on the 2-year note TMUBMUSD02Y,
3.519%
rose 4.6 basis points to just under 2.500%, while the yield on the 10-year TMUBMUSD10Y,
3.321%
rose 2.1 basis points to 3.290%.

Meanwhile, oil prices traded higher on Thursday but remained near seven-month lows from Wednesday’s session. West Texas Intermediate crude futures for October delivery CLV22,
-0.61%
rose 2.1% to $83.62 a barrel. US stocks edged higher for a second day in what would have been the first straight gain in two weeks for the S&P 500 SPX,
+0.66%,
which rose 16 points, or 0.4%, to 3,997. The Dow Jones Industrial Average DJIA,
+0.61%
was p 146 points, or 0.5%, at 31,723, while the Nasdaq rose 15 points, or 0.4%, to 11,809.

But stocks have fallen dramatically this year, with the S&P 500 down more than 16% and the Nasdaq down nearly 25%. If you include falling bond prices — which typically rise when stocks fall — 2022 was one of the worst years for markets in decades.

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