By Jamie McGeever

ORLANDO, Fla. (Reuters) – A look under the hood into what is driving the U.S. bond market sell-off since the Fed’s hawkish tilt last week suggests investors are pricing in higher interest rates more than higher inflation.

The year has seen a lot of concern about rising inflation and high input prices. You would lose any benchmark inflation hedges you bought in January despite the worry about inflation returning to 1970s levels and investors being afraid of rising prices.

Over the past week, this trend has been underlined.

This week’s increase in longer-term yields has been driven in large part by higher “real”, while rising breakevens rates (a more accurate gauge of inflation anticipations) have not moved as much and are still within the ranges that were seen in Spring.

At this point, inflation expectations measured as breakevens for five- to 30-year maturities has only increased from last month. They are markedly less than in May.

Inflation expectations as measured by forward swap rates, which is a more accurate measure of bond market distortions due to the Fed’s QE, show an identical picture. They are higher but remain below their mid-year level.

If bond markets truly believed that the current supply-driven and elevated inflation would soon become permanent demand-driven phenomena, then breakevens will be rising just as fast than nominal yields. If not quicker.

Despite this, it is still cause for concern.

The price of a barrel is now at $80 per barrel, which has doubled in the past 12 months. Recent core inflation reached 4%, the highest level in over 30 years. Although headline inflation has slowed down in August it remains above 5%.

Phillip Toews CEO, Toews Asset Management overseeing assets worth $2 billion, believes that financial markets have become too passive. According to him, there’s a 50-50 chance that inflation will reach double-digits.

He says, “We’re not in denial.”

(NOT SO) HOT TIPS

Establishing the driving force behind rising Treasury yields is important because it indicates how comfortable – or otherwise – investors are with the broad inflation outlook, and give better insight into policymakers’ thinking.

If breakeven rates do not rise, then it’s clear the Fed doesn’t have to lead the charge. Rates can increase as desired without disrupting financial market markets, provided they are contained.

The narrative of inflation accelerating rapidly in recent months, which has been questioned sharply over the last week, is that it’s threatening to outpace control. This forces the Fed into a proactive rather than reactive tightening cycle.

The global supply chain problems caused by COVID-19, from chip shortages to containers ships not being allowed to dock at ports, are fueling the problem. Some indicators of business and consumer inflation expectations have also increased.

Officials at the Fed insist that this trend is temporary, but may be more long-lasting than previously thought.

According to the Fed, nine out of 18 policymakers believe that rates will rise by 2022. That’s an increase of seven from June. And that their median forecast has moved toward tightening at a quicker pace. The Fed expects inflation to stay above the Fed’s target of 2% through 2024.

It has proven risky to buy inflation-protection securities via Treasury Inflation Protected Securities at the very least for this year. Ten-year TIPS fell by around 1.5%, while 30-year TIPS dropped almost 7%. They have fallen around 1% and 4.4% respectively since the September 22 Fed meeting.

The real yields that account for inflation have seen a rise. In August, the 10-year real yield fell to a new record low of -1.2%. Now, it is at -0.85%. That’s an increase of 35 basis factors.

This is nearly the exact same amount of rise in nominal 10-year yield, from 1.18% to 1.53%. This, along with the slow rise in breakevens suggests that investors are now repricing Fed’s response function and not permanent higher rates of inflation.

JP Morgan clients surveyed last week and found that 54% thought supply limitations were temporary while 43% expected them to be a permanent feature. Even if this balance is reversed, the breakevens indicate that investors are confident that the Fed will swiftly act to stop a further rise in inflation.

The opinions herein are the views of the author who is a columnist at Reuters.

(By Jamie McGeever. Editing done by Dan Grebler.)