How Inflation Expectations and Bond Yields Have Changed

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A lowering of expectations for future inflation is contributing to the likelihood of the Federal Reserve either being at the end or very close to the end of its current interest rate tightening cycle. This trend can be seen in both the five- and 10-year breakeven inflation rates. The breakeven rates signal what bond market participants expect inflation will be in the next five and 10 years.

Though the data is noisy, both breakeven rates have trended significantly downward since the Federal Open Market Committee (FOMC) first started raising rates in March 2022. The five-year rate is approaching the Fed’s target of 2% inflation while the 10-year breakeven rate is not much higher than it.

I like looking at the breakeven rates because they reflect actual market expectations. They are derived from bonds as opposed to economic forecasts. Of course—just like any other indicator—they are very much subject to error and change.

Another metric I keep an eye on is the yield curve. This plots the comparative yields of Treasurys with various maturities. At the time of the first interest rate hike in March 2022, the yield curve was upward sloping. Longer-term Treasurys had higher yields than shorter-term Treasurys. The yield curve has since inverted. It was already inverted at the time of the last rate hike (July 27, 2023) and remains inverted now. An inverted yield curve occurs when shorter-term Treasurys are yielding more than longer-term Treasurys.

Historically, when the three-year Treasury note has yielded more than the 10-year Treasury bond, recessions have followed, according to Duke University professor Campbell Harvey. Recessions/significant economic slowdowns have followed most prior interest rate tightening cycles as well. Whether the Fed will be able to achieve an elusive soft landing this time remains to be seen.

Part of the reason for the current yield curve inversion is the pressure interest rate hikes have put on the shorter end of the yield curve. Meanwhile, longer-term inflation expectations never experienced as severe a surge as the reported level of inflation did. Market forces also played a role in determining the shape of the yield curve—as they always do.

The ongoing inverted yield curve continues to provide opportunities for savers. Discover is currently offering AAII members 12-month certificates of deposit (CDs) yielding 5.25% and savings accounts yielding 4.40%. There are other banks and firms also offering competitive rates. Even one-year Treasury bills were yielding 4.94% as of Wednesday’s close. (You can purchase those directly from the Department of the Treasury at TreasuryDirect.gov.)

While these yields are juicy, they come with no capital appreciation. When the Fed finally begins cutting interest rates, these yields will come down. Just like it is extraordinarily difficult to time the stock market, it is also extraordinarily difficult to time when you should rotate out of cash and back into stocks. This is why it continues to make sense to allocate funds needed for long-term growth to stocks and not to cash.

As far as cash is concerned, shop around if your bank isn’t offering competitive rates. The national average for one-year CDs is just 1.73% according to Bankrate.com. Many CDs and savings accounts are paying paltry interest rates. While we can’t predict where interest rates will be one year from now, we can say that there are still opportunities to add a little extra jingle to your wallet.