This is an excerpt from MACRO BRIEF: Divergences of Belief & Expectations originally published on March 26, 2019.
Trends in energy prices are likely to stick around leading into the summer, but it should be pointed out that another divergence is forming: inflation expectations and eurodollars.
5-Year Inflation Breakeven (orange); EDZ2019 (purple)
5-Year, 5-Year Forwards (orange); EDZ2019 (purple)
This particular divergence is interesting because the complete capitulation to end monetary tightening puts Powell in a tough(er) place.
Although treasuries should be reacting to the rate of change in inflation, the primary cause of alpha has been the Fed's stance to end tightening, and this is going to cause problems if higher inflation expectations continue higher leading into a rebound in CPI, PPI, etc.
The catch 22 is that the relaxation is the policy stance gave way to asset inflation which gives the false pretense of economic stability.
It could give way to higher inflation expectations that will intimately pay off of energy prices. That will continue to pinch consumers and increase business input costs - if the trend continues.
Powell has effectively taken the Fed off the playing field, so if there were a rebound in inflation it may get to the point that it begins to deter what little economic growth is left. If the Fed has to step back in, that will certainty open up the Pandora's box of volatility.
Ironically, if the pragmatic Powell put wasn't enacted in December, the U.S. could have been on the verge of a credit event. (Remember, we are removed from whether it was his job to do so. People still blame Ben Bernanke for not acting to prevent the sub-prime mortgage crisis).