What’s the market pricing for US inflation?

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October is almost over and the US Bureau of Labor Staff — rather than collecting and checking price data — continue to be furloughed.

While it’s possible that the BLS will be able to survey firms not only on their prices in November, but also what their prices were in October, it seems increasingly likely that there will be no monthly CPI print for the first time since the series was initiated in 1921.

The absence of accurate and timely inflation data impedes households from budgeting, companies from investment planning, and makes it harder for employees to negotiate wages. And sure, it complicates the Fed’s job. Still, with around $7tn of inflation-linked bonds and contracts, traders are incentivised to have a pretty good answer. So, where do they think inflation is heading in the short-run?

It turns out that the normal places we’d go to answer this question — the market for short-dated break-even inflation rates set by inflation swaps and Treasury Inflation Protected Securities — provide wildly different answers. But before we give you these answers, let’s set out why they are so different.

The ABCs of break-even inflation rates

Think of break-even inflation rates as the rate at which you’re just as happy to hold a nominal US Treasury bond as an inflation-linked one. Eg, if you knew for certain that inflation would average 2 per cent a year, you’d be just as fine holding a TIPS bond with a 2 per cent real yield as a normal bond promising 4 per cent.

And so break-even inflation markets are pretty much a $7tn prediction market where bond-types bet on where all the future CPI releases will come out. Crucially, like any prediction market, they hang on a precise definition of the settlement event. After all, you don’t want $7tn of banks, hedge funds, etc arguing about what inflation really was. And the settlement events for break-even inflation rates are (essentially) defined as whatever the monthly BLS report says it is.

But, if Polymarket punters are to be believed, there’s little chance of the BLS doing the work needed to produce numbers anytime soon:

So yes, we know where the CPI index was. And we’d love the market to price where it will be. But in order to do this, it needs to find a way to settle.

Settlement fallbacks

These backup approaches are called fallbacks. Without a fallback process, there would be no way to price trillions of dollars’ worth of securities and derivative contracts in the event that something gets in the way of the publication of monthly numbers. You really could get into a world where hedgies, banks, etc go to court arguing about what inflation really is. And so, unsurprisingly, there is a pretty clear process to follow in just such an event.

We got in touch with the US Treasury to ask what this was for TIPS, and they directed us to Appendix B to Part 356, section 4(vi):

If the CPI for a particular month is not reported by the last day of the following month, we will announce an index number based on the last available twelve-month change in the CPI. We will base our calculations of our payment obligations that rely on that month’s CPI on the index number we announce.

Simple. And this is presumably the same fallback used by inflation swaps? Here’s BofA’s Meghan Swiber:

In September 2023, ahead of government shutdown risks, ISDA (International Swaps and Derivatives Association) published a document that stated a fallback provision that would be calculated such that: Substitute Index Level = Base Level x (Latest Level/Reference Level).

These fallbacks seem . . . different?

Basically, the Treasury’s approach means pretending that last month’s CPI inflation rate was whatever the average monthly inflation rate was over the previous year. Meanwhile, ISDA simply pretends that last month’s CPI inflation rate was whatever it was during that particular calendar month the previous year — so that the annual CPI rate stays frozen at the 3.01 per cent rate recorded at the end of September.

We’re not quite sure why ISDA chose such a different fallback process, but the consequence of their choice seems increasingly significant the longer the government shutdown persists.

Remember, the break-even inflation market is akin to a huge prediction market. Just like punters guessing when the government shutdown will end on Polymarket, traders and investors in the break-even inflation market are trying to predict the numbers that will be spat out at settlement events.

And as long as the BLS is shut, the numbers that traders are incentivised to forecast are not monthly inflation numbers. They are the numbers that fallback processes spit out. OK, having ersatz index-fixes in the short-run shouldn’t have a crazy level of impact on longer-term break-even inflation rates. But short-term break-even inflation rates are utterly borked.

Or as Jonathan Hill, head of US inflation market strategy at Barclays, puts it (his emphasis):

. . . The discrepancy in the fallbacks opens up a potentially fascinating divergence between very front-end breakevens and CPI swaps. For example, consider the TII 0.625% Jan 26. This issue has a base CPI of 237.61129 and matures on January 15, 2026. Using the fallbacks above, the implied daily reference index for the TIPS at maturity would be (14/30) * 325.604 + (16/30) * 326.411 = 326.03445.3 Given that the maturity in years is c.0.22y, this implies an annualized breakeven inflation rate of (326.03445 / 323.82632) ^ (1 / 0.22) – 1 = 3.15%.

By comparison, the ISDA fallback would imply (14/30) * 325.174 + (16/30) * 324.998 = 325.07999, which implies an annualized inflation swap rate of (325.07999 / 323.85626) ^ (1 / 0.22) – 1 = 1.76%.

This is a massive wedge between the TIPS breakeven and the matched-maturity CPI swap.

We’ve still got a little bit of time, because TIPS and inflation swaps are indexed to the CPI with a lag — specifically, in the case of TIPS, a two-month lag. This means, for example, the January 1st adjustment is actually based on the October CPI and that for February 1st is based on the November CPI. And, after a bit of kerfuffle, the September CPI print finally got published last week. So the daily indexation schedule referenced by TIPS will run through the end of November.

But after that we’re in the land of the fallback. Annual US inflation rates could double or halve. But to TIPS holders the fallback will put them in the 3.2-3.7 per cent range. And to ISDA-beholden US inflation swap traders they’ll forever be 3.01 per cent.