Composite of US Fed and ECB
© Bloomberg

Inflation has begun to stir, according to some prices in US bond markets that show investors anticipating a change in the economy, which could give the Federal Reserve greater room to raise interest rates.

The five-year break-even rate, a widely watched market indicator of inflation expectations, has risen to its highest level since August. Known as an imperfect gauge of real world activity, it is nonetheless the latest sign of a growing optimism ahead of a key Fed meeting this month.

Laurence Mutkin, global head of rates strategy for BNP Paribas, said: “When you look at the US inflation picture it’s increasingly difficult to find an inflation index which is not already at 2 per cent, or above the Fed’s target.”

Movement in break-evens over recent weeks came as the S&P 500 share index recovered most of the losses experienced in a turbulent start to the year and oil prices rebounded from 12-year lows.

Some now predict further action from the Fed, following on from December’s rise in interest rates, the first in almost a decade, highlighting the divergence from Europe, where the central bank is expected to announce further stimulus measures this week.

Expectations for US rate increases had dwindled as financial markets shuddered their way into the new year, with the chances of any rate rise in 2016 falling from 90 per cent to 50 per cent now, as implied by short-term interest rate futures.

“There is going to be tightening of monetary policy by more than is expected by the average investor,” said John Higgins, chief markets economist for Capital Economics, which anticipates three further rate rises from the Fed this year.

The five-year break-even rate is calculated from the difference between prices for normal government debt and bonds where the coupon is linked to the rate of consumer price inflation.

It reflects other factors as well as inflation expectations, such as the general demand for bonds and assessments of the risks attached to them, and much of the debate about causes of a longer-term decline in break-even rates over the past two years has centred on these effects.

Unofficial estimates of these factors have not materially changed this year, however.

“You can attribute the recent rise in break-evens to a general rise in inflation expectations”, said Mr Higgins.

Traders of inflation linked bonds also pointed to reduced issuance of them by the US Treasury boosting demand and so prices, along with the recovery in prices for oil and stocks, and the impact of rising housing costs.

In Europe, where recent economic data showed that consumer prices fell in February, five-year break-evens have recorded the largest weekly rise in 15 months.

After three months of steady declines, however, it was only sufficient to return five-year break-evens to 1.5 per cent, a level which until last month was a post-crisis low.

“Although it’s nice to see a bounce, we’re still at extremely low levels relative to history for break-evens,” said Mr Mutkin.

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