Is the Market Underpricing Inflation? Vanguard Thinks So

Vanguard Asset Management is buying insurance against stickier US inflation after an oil-market gauge, the crack spread, reached a 2022 high.

The firm’s active funds team opened a long position in short-dated inflation-protected Treasuries. It is betting that markets underprice the risk that price pressures linger longer than expected.

An Oil-Market Signal Bond Investors Rarely Watch

The crack spread measures the difference between the prices of refined fuels and the crude oil used to make them. It is a typical metric for oil traders. For bond investors, it barely registers.

However, the crack spread has widened to its highest level since 2022. Crude has slumped since the fragile US-Iran ceasefire. 

Gasoline has fallen, but has not matched the drop. At the same time, jet fuel, diesel, and fuel oil are also behaving differently in relation to oil prices.

It is worth noting that elevated fuel prices keep inflation sticky even as crude prices fall. Two forces are squeezing the fuel supply. 

The Iran war cut how much fuel the world’s refineries produce. Ukrainian attacks on Russian plants pushed Moscow to ban diesel exports, tightening supply further.

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Why Vanguard Sees Underpriced Inflation Risk

Ales Koutny, head of international rates at Vanguard’s active funds, said his team is monitoring the spread for signs that fuel prices will rebound and feed inflation.

“The question is whether the spread will normalize, or will the low correlation become a more structural feature which could impact inflation risks. These deviations could affect both sides of the argument, and this could be quite significant,” he said.

The backdrop is shifting fast. Iran reportedly struck three ships in the Strait of Hormuz, prompting fresh US strikes. Trump then said the June memorandum with Tehran was “over,” sending oil prices up.

Meanwhile, the two-year breakeven rates have tumbled to near their lowest in almost two years. That level implies markets expect inflation to hover only slightly above the Federal Reserve’s 2% target.

Koutny’s team disagrees. The team has paired its short-dated Treasury position with breakeven trades further out on the curve. It sees markets as underpricing the chance that inflation runs longer than expected.

Bloomberg reported that the team is also reworking its models to fold in individual oil distillates, not just crude, as a way to read inflation risk.

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