Market Responses to the CPI: Inflation Breakeven, Term Spread, Dollar

The CPI surprised on the upside by 10 bps relative to Bloomberg consensus (also higher vs. Cleveland Fed nowcasts). How did financial markets respond?

The 5 year breakeven (unadjusted for inflation risk, liquidity premia) fell 5 bps.

Figure 1: Five year inflation breakeven calculated as 5 year Treasury yield minus TIPS yield (blue, left scale), and Ten year-three month term spread (brown, right scale), both in %. Source: Federal Reserve Board via FRED, and author’s calculations.

Not much of an effect on the term spread. The 5 year 5 year forward expected inflation fell as well.

Figure 1: Five year five year inflation forward in % (blue). Source: Federal Reserve Board via FRED, author’s calculations.

Longer term inflation expectations seem well anchored, pretty much the same as mid-January 2021.

Finally, in a sticky price world where there’s a Taylor rule in place, one would’ve expected a dollar appreciation on the inflation surprise (as in Clarida (2007)). Instead, the dollar stayed flat.

Figure 3: US dollar/euro exchange rate (blue), up is dollar depreciation. Source: Federal Reserve Board via FRED, Pacific Exchange Services.

To me, this means the market was not particularly surprised by the CPI number, notwithstanding the headlines about record y/y inflation. That makes sense to me as soon as one realizes that month-on-month inflation continued to fall in December.