J.P. Morgan's Kelly: Why the Bond Market Is Ignoring Inflation

What You Need to Know

  • Long-term Treasury interest rates have gone down despite a gain in overall CPI.
  • Investors may be taking the Fed’s cue, or technical forces may be suppressing long-term bond interest rates.
  • The economy’s rapid reopening and robust labor demand should lead to a brisk increase in employment.

Recent reports have shown consistent upside surprises on measures of wages and home and consumer prices, culminating in the June 10 U.S. Bureau of Labor Statistics consumer price index report for May, which showed a 5% year-over-year gain in overall CPI, and a 3.8% increase when food and energy are excluded. 

Despite this, however, long-term interest rates have edged down, with the 10-year Treasury yield falling to 1.45% on June 10, its lowest level since the start of March.

There are two broad possibilities why this is happening, David Kelly, chief global strategist at J.P. Morgan Asset Management, said in a weekly note.

Kelly said investors may perceive some weakening in the pace of recovery and agree with Federal Reserve officials who maintain that any near-term price pressures are merely part of a transitory interlude before a return to stable or falling inflation.

A second possibility, he said, is that technical forces in the bond market are suppressing long-term interest rates, at least for now.

Kelly said it behooves investors to pay attention to this debate because if the Fed is wrong and higher inflation becomes imbedded in the economic landscape, technical forces should eventually subside. This would allow long rates to move higher and restart the rotation from growth to value, which has characterized much of this year so far.

According to Kelly, those who argue that inflation pressures are actually easing could point to two consecutive jobs reports that have disappointed both with respect to payroll gains and declines in unemployment. 

He noted, however, that healing in the job market most likely is just being delayed by a few months because of lingering effects of the pandemic and relatively generous unemployment benefits. In fact, the economy continues its rapid reopening, and enhanced unemployment benefits will expire in half the states by early July and the other half by early September.

This combined with evidence of robust labor demand — confirmed by the June 8 Job Openings and Labor Turnover report — should lead to a rapid increase in employment and decline in unemployment over the next six months, Kelly said. In the meantime, wage growth has clearly accelerated, and this should continue to add to inflation pressures into 2022.

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