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The U.S. market is sending a worrisome signal on inflation
Market-implied inflation expectations hit 15-month low
NEW YORK (MarketWatch) — Investors are downgrading their expectations for inflation over the next half decade, sending a concerning signal about the pace of the U.S. economic recovery.

Market-implied inflation forecasts took a nose-dive after Federal Reserve policy members suggested a more aggressive timeline for hiking key short-term interest rates last Wednesday.

One of the more closely-watched gauges of consumer prices fell for the first time in 16 months, showing that the specter of inflation growth emerging during the second-quarter didn’t quite manifest. The annual rate came in at 1.7%.

A look at breakeven rates tells us a lot about where the markets think inflation is headed. The So-called breakeven rates are the difference between 5-year Treasury note 5_YEAR, +1.31% yields and 5-year Treasury inflation-protected security yields. The differential, representing the rate of inflation necessary for TIPS to outperform their nominal counterparts, acts as a rough gauge of where inflation might be headed over the coming five years.

Breakeven rates dropped to a 15-month low of 1.66% on Monday from 1.86% on Sept. 16. It was at 1.70% on Tuesday.

Most economists believe some level of inflation is important to a healthy economy. The U.S. central bank is targeting a 2% annual rise in consumer costs. The drop in market forecasts for inflation implies investors think the Fed will abandon that mandate and raise rates

“Part of the move in the market has been that fundamental story that maybe the Fed has a more hawkish reaction function than before. Part of it is positioning,” said Michael Pond, head of global inflation-linked research at Barclays.

If inflation goes by the wayside as the Fed exits its easy money policies, long-term rates like the benchmark 10-year Treasury note 10_YEAR, +0.59% yield would likely stay low even as short-term rates rise.

But markets could be overreacting. If inflation gauges rebound and market participants receive confirmation that the Fed is committed to hitting a healthy inflation level before raising rates, expectations could revert

“We think the underlying trend in inflation is higher and that we will move above 2% on core CPI,” Pond said. “We think the market is cheap from that perspective.”

For the sake of healthy inflations levels, let’s hope that’s the case. http://www.marketwatch.com/story/the-us-market-is-sending-a-worrisome-signal-on-inflation-2014-09-24