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Inflation expectations are ‘collapsing’ — here’s why that could spur a rebound in stocks

A closely watched U.S. bond-market gauge of near-term inflation expectations has fallen below the Federal Reserve’s 2% target for the first time in two years in a sign that stocks could find some near-term relief after the Nasdaq Composite
COMP,
+0.60%

suffered its longest losing streak since 2016 in the past week.

The drop in the one-year breakeven inflation rate is just the latest sign that “inflation expectations are collapsing”, largely thanks to a drop in oil prices, according to Jonathan Golub, chief U.S. equity strategist and head of quantitative research at Credit Suisse.

The TIPS/Treasury Breakeven Rate is calculated as the difference between the treasury yield and the treasury inflation-indexed security yield.

This pullback in inflation expectations should ameliorate the need for the Federal Reserve to follow through with aggressive interest-rate hikes, which could be a salve for the market.

“The Fed isn’t trying to control the next inflation print, they’re trying to control what inflation is going to look like 12 to 18 months in the future,” Golub said during a phone interview with MarketWatch.

“And if the expectation is that inflation is coming down…all else being equal, it means that policy doesn’t have to get tighter.”

To be sure, the drop in the one-year breakeven rate isn’t the only encouraging indicator regarding inflation expectations. A consensus forecast by Bloomberg shows economists expect the consumer-price index to fall to 2.7% during the fourth quarter of 2023.

Investors will receive the next update on inflation expectations on Tuesday when the CPI for August is released. Other recent inflation data has been encouraging as well, including the Institute of Supply Management’s manufacturing gauge, which showed prices paid by U.S. manufacturers declined to their lowest level since June 2020, while prices paid for services companies fell to its lowest level since January 2021.

But while a drop in oil prices has helped suppress near-term inflation expectations, there are other obstacles that could give the Fed pause. For example, while near-term gauges of inflation expectations have declined, longer-term gauges haven’t seen as big of a drop, a sign that the cost of housing, education, health-care, transportation and other factors that feed into so-called “core” inflation could be far more difficult to contain.

“The [one-year] breakeven drop is a bit misleading because it largely reflects oil effects. The rising slope of the breakeven curve suggests that the market is less optimistic about core inflation. In fact, it looks like the market expects CPI inflation around 3% two and three years out despite the drop in near term break-evens. I think these numbers worry the Fed,” said Steve Englander, global head of G-10 currency strategy at Standard Chartered, in comments e-mailed to MarketWatch.

See: Will the stock-market rally turn into a selloff? This bond-market gauge could tip investors off

While the one-year breakeven inflation rate is just a hair below 2%, the five-year breakeven is stuck at 2.5%, according to data from the St. Louis Fed. That’s down roughly 50 basis points compared with its level from June 15.

By comparison, Treasury yields continued to climb on Thursday, with the yield on the 2-year note
TMUBMUSD02Y,
3.502%

up 4.6 basis points to just below 2.500%, while the yield on the 10-year
TMUBMUSD10Y,
3.299%

was up 2.1 basis points at 3.290%.

Meanwhile, oil prices traded higher on Thursday, but still remained near the seven-month lows from Wednesday’s session. West Texas Intermediate crude futures for delivery in October
CLV22,
+0.34%

were up 2.1% at $83.62 per barrel. U.S. stocks were on track to rise for the second consecutive day, what would be the first back-to-back gains in two weeks for the S&P 500
SPX,
+0.66%
,
which was up 16 points, or 0.4%, at 3,997. The Dow Jones Industrial Average
DJIA,
+0.61%

was p 146 points, or 0.5%, to 31,723, while the Nasdaq advanced 15 points, or 0.4%, to 11,809.

Still, stocks have fallen dramatically this year, with the S&P 500 down more than 16% and the Nasdaq down nearly 25%. If one includes the drop in bond prices — which typically rise when stocks fall — 2022 has been one of the worst years for markets in decades.

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