U.S. retail prices surge, but investor opinions remain divided

The U.S. retail prices data on Wednesday shows a surge in inflation, even if price pressures worsen in the very near term, but investor opinions should vacillate amid divisions about how soon the Federal Reserve will act to choke off rising prices.

The U.S. Consumer Price Index increased more than expected in October as the cost of gasoline and food surged, leading to the biggest annual gain since 1990, further signs that inflation could remain uncomfortably high in next year amid scarred global supply chains.

Even as nerves grow over an acceleration in price pressures near-term, longer-dated measures show that they are unlikely to last.

The signals that we are getting from the breakeven market is that all s well, at least on longer run inflation trends, said Subadra Rajappa, head of the U.S. rates strategy at Societe Generale in New York.

The Treasury breakeven inflation curve, a measure of what inflation level a investor would break even on a given Treasury note yield, shows that investors expect inflation to run at 4,80% in the coming year before falling to 3.65% in two years, 3.16% in five years and 2.68% in 10 years.

The five-year forward inflation rate, which measures where annual inflation is expected to be in five years, was last at 2.30%, according to the Fed's favorite indicator. It was below the 2.41% level reached on Oct. 15, which was the highest since 2014, which was the highest since the year.

It hasn t really broken through even 2.50%, so to me that should make the Fed feel comfortable that the market s not pricing in, or at least not expecting runaway inflation, said Rajappa.

The Fed is targeting an average annual inflation of 2% but said that it would allow inflation to run hotter than usual to make up for previous under performance.

Fed officials including Chair Jerome Powell said last week that the inflation surge is transitory, and Powell said last week that he expects it will moderate next year.

Some investors are not as confident.

Two-year yields have surged and the yield curve has flattened as investors adjust to the prospect of tighter monetary policy while fed funds futures are showing that investors expect the U.S. central bank could raise rates as soon as July 2022.

The most meaningful trend I think is flattening the curve, as the market is kind of assuming a more aggressive normalization path from the Fed, said Ben Jeffery, an interest rate strategist at BMO Capital Markets in New York.

Brian Reynolds, chief market strategist at Reynolds Strategy, said that some difference between investor outlooks can be explained by how they define transitory, while some equity investors have interpreted the word to mean months, while fixed-income investors see it as years.

There is a camp of equity investors who are convinced that it s going to be permanent, and they seem to be playing in the interest rate space, forcing short term rates to rise in anticipation of the Fed following suit because of inflation, said Reynolds.

In two years of rising inflation, the fixed income market has priced two years of rising inflation and then inflation coming back down after that. In the last couple of months, they've priced a little bit more inflation in the next two years, and a bigger slowdown in the ensuing year, Reynolds said.

The takeaway for now is that the debate over inflation has become a little more volatile, said Reynolds.

Analysts at TD Securities said this week that inflation will slow significantly in 2022 as fiscal stimulus fades and supply constraints ease, even though price pressures may continue to climb in the near term.

The bank expects annual CPI increases to drop to 2.1% by December 2022, and core CPI to drop to 2.3% in the same time frame. The numbers were 6.2% and 4.6% last month.