Commodity prices have tumbled recently, and inflation expectations have been pared too, albeit only modestly. Is there a connection? Yes, or so it appears. But for the same reason that we should be cautious in reading too much into the inflation outlook based on a surge in prices of raw materials, the caveat applies when prices fall. Short-term commodity prices are too volatile to use as a lone source for gauging prospective inflation. Nonetheless, it’s hard to overlook the recent shift in the Treasury market’s forecast.

After hitting the recent peak of 2.63%, the inflation outlook based on yield spread between the nominal and inflation-indexed 10-year Treasuries dropped to 2.43% as of yesterday. That’s a modest retreat from 2.63% reached at one point last month. But let’s not oversell this change. Based on the last several years of trading data, an upper range of comfort appears to be in the neighborhood of 2.5%. A convincing move above that level for a sustained period would be a warning sign of some significance. For the moment, however, the market is telling us that inflation’s threat looks subdued.

That’s good news, or is it? With all the chatter about inflation’s rising threat in recent months, the falling forecast is encouraging, right? To a degree. But if inflation continues to decline, at some point it would signal anxiety for the economic outlook. Recall that a year ago this month the market’s inflation forecast fell sharply. At the time, I wondered if the trend was a clue that trouble was brewing. As it turned out, it was an early warning sign of the summer soft patch for the economy.
So far, the fading inflation forecast is mild this time around. Nonetheless, investors should keep a close eye on the trend in the coming weeks. The connection with lower commodity prices—oil’s dip in particular—may be critical. The International Energy Agency trimmed its prediction for energy demand due to higher prices of late and a slower pace of economic growth in the developed world, TheStreet.com reports.
“The increase in inflation this year appears to reflect pressures that were largely the result of growing global demand and some supply-side or geopolitical shocks,” Federal Reserve Bank of Atlanta President Dennis Lockhart advised in a speech yesterday. “The inflationary impact of some supply shocks is likely to be temporary. In fact, prices of several commodities have either leveled off or declined recently.”
But too much of a good thing can bite back. The economic recovery has been modest at best. Meanwhile, there’s a number of ongoing risks, including a fear that the real estate market may be headed for another rough spell… again.
For the moment, lower inflation expectations is a positive. But if this trend has legs, it may spell trouble. The outlook for growth still isn’t strong enough to see lower inflation (or lower interest rates) at this stage as bullish. “Treasuries are supported by the general market angst about falling equities and concern over the U.S. economy,” Marc Ostwald, a fixed-income strategist at Monument Securities in London, tells Bloomberg today. “Today’s 30-year auction will be a reasonable test for the markets, given the low yield levels we’re at.”