Evening Brief – 04.21.23

The data comprising many economic indicators tends to lag and is subject to sizable revisions. The bond market can provide a more real-time view of expectations for inflation and economic growth because it reflects the collective wisdom of investors who are constantly assessing the risks and opportunities of various economic outcomes.

Breakeven inflation rates are an important metric used to gauge inflation expectations. Breakeven inflation rates represent the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-protected investment, both with similar maturity and credit quality.

The 10-year breakeven rate peaked around 4.8%, well below the Fed’s preferred measure of inflation, the trimmed-mean Personal Consumption Expenditure (PCE) rate, which peaked just shy of 3%.

The bond market is betting on a significant decline in inflation over the next 12 months, indicating investors are anticipating weaker economic growth. If the Federal Reserve continues to hike rates, this could potentially increase the risk of a decline in breakeven rates, particularly if the Fed’s actions lead to a recession.

Given that the rise in earnings and corporate profits in recent years partially resulted from massive fiscal interventions, investors should be asking what will drive growth next? If the downtrend in M2 and falling breakeven rates is an indication, it is likely that earnings growth, and ultimately profits, may be challenged.

Falling inflation is not a function of a growing economy, so the Fed has reiterated its call for a “mild recession.” When the Fed does begin to cut rates, it is likely due to the recognition that a recession is underway or that the economy is facing significant headwinds that could lead to a recession. The yield curve will steepen dramatically, lowering yields, as inflation eases with slowing economic activity.