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A Drop in Inflation Expectations Could Be Troubling

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Indeed, the drop in inflation expectations is particularly worrisome. U.S. 10-year inflation expectations (derived from the Treasury Inflation Protected Securities (or TIPS) market) are at 1.6 percent, near January lows and down more than 50 bps from a year ago, according to Bloomberg data. Historically, the impact of a Fed hike has been partly a function of whether or not real interest rates were rising. In an environment in which nominal rates are going up due to the Fed, but inflation expectations are falling, real rates would be rising sharply, albeit from a low level. In the past, based on a BlackRock analysis, this combination has been associated with lower returns.

Investors should pay less attention to the calendar and more to the probability of a September rate hike and changes in inflation expectations. These two data points are likely to prove more important in determining whether we get a September swoon than the time of the year.

drop in inflation expectations

Market Realist – The recent plunge in crude oil prices (BNO) and the fall in ten-year Treasury yields (TLT) have caused a drop in inflation expectations. With the dip in global commodity prices, inflation expectations have taken a nosedive as well. You can see this in the above graph.

drop in inflation expectations

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The five-year, five-year forward inflation expectation rate—a gauge of inflation expectations—dropped to 1.87% on Monday, August 24, 2015. This has been its lowest-ever level in almost five years. According to Bloomberg, the ten-year breakeven inflation rate plunged to 1.49% on the day while the two-year breakeven rate fell to 0.7%. You can see this in the above graph.

drop in inflation expectations

As we described above, the combination of rising real rates and falling inflation expectations has historically been associated with negative S&P 500 returns. In the first quartile, the damage is particularly high.

All in all, the September effect is not the only worry for investors next month. Investors should watch out for cues from the Federal Reserve regarding the rate hike timeline. Investors tend to avoid rate-sensitive segments of the market like utilities (XLU) and consumer staples (XLP). Emerging markets (EEM)(VWO) are likely to be negatively affected by a US rate hike as well. China (FXI) is already feeling the heat on account of the economic slowdown. Investors may tread cautiously in the next month, not just because of the September effect, but also due to general macroeconomic cues.

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