How the Fed is posing a risk to market sentiment

Today’s chart of the day looks at the breakdown in market expectations of inflation (TIPS breakeven spread) and the 10-year Treasury rate in the context of tomorrow’s Federal Open Market Committee (FOMC) meeting. What’s notable about these data points is the recent disconnect between rates and inflation expectations. Movements higher in the breakeven spread suggests rising market expectations of inflation.

Recently these expectations have fallen in tandem with a drop in headline inflation. Treasury rates on the other hand have not eased and continued to move higher this week. This is important because policymakers at the Fed meet tomorrow to discuss whether to raise rates.

While this month’s meeting is not expect to yield a hike by the Fed, market expectations are set for policymakers to take action at their December meeting. Trouble may crop up for financial markets if the Fed signals a more aggressive policy stance in light of weaker inflationary pressures.

The risk of yield curve inversion is likely to rise if the Fed continues to drive short rates higher through its policy tightening and as 10-year rates converge with inflation expectations (reversing the recent divergent trend).

Inversion could be perceived by financial markets as a precursor to a recession, reigniting financial market volatility. While we do not expect a recession to occur this year or next, we believe that the chances of a misstep by the Fed will increase as policymakers continue hiking rates in an environment of subdued inflation expectations.

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