August 3, 2021

Chart of the Week: What can the swaps market tell us about future inflation?

by Fathom Consulting.


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Our answer is “not much”! Back in March 2020, during the early stages of the pandemic, investors were pricing in a period of outright deflation in the US lasting up to three years. At the time, we argued they had gone too far. It was not clear to us that the pandemic, when combined with the policy response, would prove to be net negative for inflation. Late last year, as it became clear that a number of vaccines had proved highly effective in clinical trials, we warned our clients of the risk of a material, cyclical upturn in inflation as pandemic savings were spent. Earlier this year, that became our central case. Investors had been coming round to our way of thinking, with two-year US inflation swaps hitting post-GFC highs in May. More recently, measures of inflation expectations derived from market pricing have fallen back somewhat, perhaps as investors have bought into the official line that the pickup in inflation will prove temporary. Should we take comfort from this reassessment? Not necessarily. As this week’s chart shows, measures of US inflation expectations derived from the swaps market are a poor predictor of subsequent inflation outturns. In fact, the correlation between the two series in our chart is negative. The lower the two-year inflation swap rate is today, the higher inflation is likely to be, on average, over the next two years.

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