(Bloomberg) -- The bond market is sending a warning to the Federal Reserve: a false step could leave the U.S. bogged down in a disinflationary quagmire well into the next decade.
The Fed has pumped almost $4 trillion into the financial system through debt purchases and kept interest rates near zero for seven years to help push price gains toward its 2% target. Yet break-even rates -- the gap between fixed-rate and inflation-indexed Treasuries -- suggest investors see a growing risk policy makers will drive prices in the other direction if they start raising interest rates next month.
U.S. government debt is “priced for inflation never to pick up,” said Michael Pond, head of global inflation-linked research in New York at Barclays, one of 22 primary dealers that trade with the Fed. “The market is implying that tightening will be a policy error.”
The decline in break-even rates to levels at or below those reached in January -- before the European Central Bank began $1.1 trillion of its own bond purchases and China devalued its currency -- is even more alarming given that global policy makers now have fewer tools at their disposal to boost prices.
“If they had little to work with in the past, they have virtually nothing to work with now,” said Gregory Whiteley, a money manager at Los Angeles-based DoubleLine Capital, which oversees $76 billion.
The drop in inflation expectations has accelerated since the Fed’s July meeting, where policy makers appeared intent on raising interest rates before year-end.
Two-year Treasury breakevens fell to within a quarter-percentage point of zero on Thursday. What’s more, expectations for inflation in Germany have fallen to 0.37% over the next five years, while in the U.K. they’ve tumbled to 2.25%, down 0.44 percentage point from just three months earlier.
In the options market, traders are also wagering that inflation will cool. They’re paying the most since July 2012 for two years of protection against declining U.S. prices. Oil fell as low as $40.65 on Friday, headed for the longest run of weekly declines in almost three decades.
Longer-term inflation forecasts, traditionally less sensitive to energy prices, haven’t been immune. One measure of 10-year forecasts for inflation neared its lowest level in five years on Thursday.
“It’s not looking pretty in the inflation market,” said George Goncalves, head of interest-rate strategy at Nomura Holdings, also a primary dealer. “Where’s the fire? Where’s the rush to hike?”
Still, minutes from the central bank’s July policy meeting, released Wednesday, showed officials are concerned about stubbornly low inflation, leading traders to scale back odds of a rate boost next month.
The probability traders assign a rate rise in September has dropped to 32% from about 50% earlier this week, based on the assumption that the effective fed funds rate will average 0.375% after liftoff.
“I don’t see them hiking unless the data all of a sudden takes a turn,” said Ed Acton, a U.S. government-bond strategist at RBS Securities in Stamford, Conn.
Even so, the bond market’s forecasts for inflation continues to drop. Officials may dismiss the decline on the view that it’s correlated with falling energy prices, said Pond at Barclays. Other commodities, including nickel and copper, have tumbled this year as global demand slows.
The biggest risk is “you tighten and you realize it’s in an environment where the global economy is weakening and the U.S. economy is weakening by default as well,” said Jack McIntyre, a moneymanager who oversees $58 billion at Brandywine Global Investment Management in Philadelphia.