Economist Reacts To Flattening Yield Curve

The Federal Reserve shifted market expectations in a significant way on Wednesday with its updated dot plot projections and commentary related to inflation.

The SPDR S&P 500 ETF Trust (NYSE: SPY) is down 2% since Tuesday’s close, and the yield curve in U.S. Treasuries has flattened significantly.

On Wednesday, the Fed raised its 2021 OCE inflation forecast by 1% from 2.4% to 3.4%, well above its long-term target of 2%. In addition, the latest dot plot suggests two rate hikes by the end of 2023. On Friday, St. Louis Fed President James Bullard told CNBC that the Fed has observed “more inflation than we were expecting” and could potentially raise interest rates by the end of 2022.

Market Fallout: RSM Chief Economist Joe Brusuelas said Fed credibility is at the heart of the market action in recent days.

“The shape of the entire yield curve is resetting with a flatter slope as the spread between the 30-year less 5-year yield standing at 111 basis points down from 156 basis points as recently as May 13, 2021,” Brusuelas said Friday.

“This strongly implies that investors are pulling back on expectations of inflation remaining sticky and are beginning to price in a more benign inflation outlook in line with the Fed’s forecast of a transitory or temporary increase in inflation this year and next that then falls back towards the intertemporal target of 2%.”

While some investors are very concerned about elevated inflation levels, Brusuelas said the Fed’s five-year, five-year forward inflation projection remains at just 2.17%.

“From our point of view this is forward looking investors signaling to both buyers and sellers in financial markets, as well as the broader policymaking community, that the risks to the economic outlook linked to inflation are overblown,” Brusuelas said.

As the market digests the recent Fed news, Brusuelas said the next major Fed-elated catalyst could come in late August when the Fed will likely talk more explicitly about tapering its asset purchases at the annual Jackson Hole Economic Symposium.

Benzinga’s Take: A 1% jump in the Fed’s inflation expectations may have spooked investors, but the Fed has repeatedly said the current inflation levels are “transitory” as the economy reopens fully following pandemic shutdowns. However, the bond market is now pricing in a 42.3% chance of at least one rate hike by July 2022, suggesting rising prices may force the Fed to take action much sooner than its 2024 expectations back in March.