Fed Credibility Crisis Fuels Demand for Inflation-Protected Bonds

The Federal Reserve's potential inability to control inflation has investors seeking refuge in inflation-protected bonds. These securities adjust their interest payments upward when inflation rises, ensuring that income keeps pace with living costs.

After Fed Chairman Kevin Warsh declined to outline how policymakers would control inflation, long-dated US yields surged to levels not seen since almost two decades ago. This increase stoked worries that the Fed might act too late in addressing rising prices.

The market's inflation expectations, or breakevens, are near their lowest level in a year. Some investors see this as an attractive time to buy inflation protection, especially if they believe the Fed will tolerate faster inflation than its 2% target.

HSBC's Dhiraj Narula argues that uncertainty about the Fed's commitment to long-run inflation control makes owning long-term US government debt linked to inflation a wise decision. Barclays' Jon Hill expects investors to price greater inflation risk into longer-term bonds, pushing breakevens higher and helping indexed debt outperform conventional bonds.

Rabobank's Stefan Koopman suggests that the investment case for inflation-linked bonds is not just about inflation staying above 2%, but also that 2% may increasingly act as a floor rather than a ceiling.