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Jan. 12, 2018, 7:52 a.m. EST

Why U.S. inflation data will be a litmus test for bond market

Consumer price data is set for release on Friday

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By Sunny Oh

Sean Gallup/Getty Images
Will we be seeing this less in 2018?

As expectations for inflation heat up, the December consumer-price index set for release on Friday will command the attention of investors looking to gauge whether the bond market’s expectations for higher price pressures will pan out, or fizzle in its usual style.

For much of 2017, the 2% inflation goal has remained elusive despite the tightest labor market in decades, leading the Federal Reserve and Chairwoman Janet Yellen to describe its absence last year as a puzzle. Against that backdrop, the central bank has struggled to justify its three projected rate increases in 2018.

See : Inflation outlook still baffles the Fed

That’s why Friday’s reading along with the next few months of CPI data will serve as a litmus test to bond buyers. If inflation rises more than expected, complacent investors who bought long-dated debt may rue their decision, especially if the central bank takes the opportunity to tighten monetary policy faster than anticipated. But if the data falls short , market participants might have to wait longer for the bond bull market to end.

Economists surveyed by MarketWatch forecast the core consumer-price index, which strips out the volatile food and energy categories, will show a monthly gain of 0.2% and an annual rise of 1.7%.

Economic Preview : Is inflation ever coming back?

Last week, the 10-year break-even inflation rate, a market-based measure of expected inflation, exceeded 2% level for the first time since March. Considered the bond market’s gauge for inflation over the next decade, it’s the difference between the yield of a 10-year Treasury note and inflation-linked security of the same maturity.

These assets have grown attractive to investors as inflation fears have resurfaced. Bonnie Anasetti, who trades TIPs, or Treasury inflation-protected securities, for Jefferies, estimates almost $5 billion has poured into such instruments over the past 11 weeks.

St. Louis Federal Reserve
Inflation expectations are making a return to 2%.

Earlier in 2017, investors shed long-dated Treasurys on concerns that President Donald Trump’s pro-growth legislative agenda combined with a Republican-controlled Congress would pass bills needed to spur inflation. Expectations for the so-called Trump bump had lifted inflation expectations above 2%. But when the White House encountered resistance, such expectations slumped.

To be sure, inflation forecasts have ticked higher after tax-cut legislation won approval in December. Economists said the legislation should spur growth and inflation in an economy nearing full capacity.

Yet with wage gains failing to materialize, investors could be setting themselves up for another letdown. Even as the Fed insists a low unemployment rate should pave the way for inflation to make a comeback, last week’s jobs report showed average hourly earnings rose in December to a tepid 2.5% in the past 12 months, up from 2.4% in November. Without thicker pay packets, consumers are unlikely to boost spending and, thus, inflation.

“The crucial link between wage growth and inflation gains is still very much missing,” wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.

The recent rise in inflation expectations may be coming from a different source—commodity prices.

Copper prices touched a 4-year high in December, while the U.S. crude-oil benchmark appears to have gained a firm foothold above $60 a barrel, amid a broad commodity rally.

That’s in line with the analysis of Laura Desplans, a macro strategist at Deutsche Bank, who found that prices for metals, crude oil, and stocks were the principal drivers of daily shifts in break-even rates.

Regardless of what Friday’s reading reveals, some say the outlook for higher price pressures won’t deter investors from plunging into the long-end of the market. The contrarian position runs against the widely followed belief that inflation is bearish for bonds.

Lyngen said a spree of solid CPI data might only embolden the central bank to take a more aggressive tack. He added the Fed hiked its benchmark interest rate three times even when inflation undershot its 2% target. That would entrench the yield curve flattening trend which has encouraged hedge funds and speculative traders to buy long-dated Treasurys and sell shorter-dated peers on the expectation for the yield gap between both assets to narrow.

“A weak inflation print will not make or break the Fed’s hike path for the year and, as the minutes emphasized, the Fed has divorced the hike path from the inflation and employment reads to some extent,” said Lyngen.

In the minutes of the December Fed meeting released last week, several officials indicated they were open to the prospect of more than three rate increases in 2018. At the same time, others on the policy-making panel raised concerns that inflation would struggle to pick up.

See: Fed minutes show a divide over its own forecast of 3 rate hikes this year

Sunny Oh is a MarketWatch fixed-income reporter based in New York.

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