PMC Weekly Review - July 15, 2016
Low inflation has been the norm in much of the western world since the Great Recession, and broad price increases have been nearly nonexistent in Japan since the early 1990s. In the United States, the Federal Reserve’s (Fed) preferred measure of inflation, the personal consumption expenditures index (PCE), has hovered below the Fed’s 2% target since 2012 – well below its historical average. Whereas the low growth in prices is good for consumers’ wallets, it goes hand in hand with lower economic growth and indicates a mismatch between aggregate supply and demand for goods and services. Perhaps more importantly for bond investors, any change in the current paradigm could present a challenge for their portfolios.
Attempts by central bankers to remedy the situation, such as ZIRP (zero interest rate policy), purchases of sovereign and corporate bonds, and negative interest rates, have been unsuccessful in spurring their economies back to pre-crisis growth levels and stoking higher inflation. Although they have decreased the cost of borrowing for governments, firms, and consumers, such efforts have been most successful in inflating the prices of sovereign and corporate bonds, as well as equities. Just this week, Germany became the second major economy (after Japan) to issue a 10-year note with a negative yield. Last week, the yield on generic 10-year U.S. Treasury notes reached an all-time low of 1.37% following Britain’s decision to leave the European Union.
Despite the historically low yields on U.S. Treasuries, the even lower, or non-existent, income paid by the debt of the governments of Japan and many countries in Europe has created an incentive for investors in those countries to search for greener pastures. This flood of assets from abroad has anchored U.S. Treasury yields just as the Fed had wanted to return to some semblance of normality. With the yields on developed market sovereigns at historic lows, there is little in the way of income to cushion investors against an unexpected spike in interest rates. One event that could precipitate this spike would be a sudden jump in inflation and/or inflation expectations. For example, a short-term inflation scare could lead to an event similar to the spike in German Bund yields last year, when the yield on the 10-year note shot from 6 basis points to over 1% in two months.
But how likely is an inflation scare in the U.S.? To answer this question, we need to understand what the market anticipates inflation to be going forward and whether there is any clear catalyst to change these expectations. To derive market inflation expectations, market participants generally look at the difference, or spread, in the return offered by inflation-linked government bonds (“TIPS” in the U.S.) and nominal bonds that are not indexed to some measure of inflation. The current five-year TIPS spread is 1.43%, which is below the 2% spread that would coincide with the Fed’s inflation target. This indicates that the market does not believe inflation will reach the Fed’s target over the next five years. Another popular measure derives anticipated inflation from interest rate swaps. The “five-year, five-year” swap, which refers to the rate paid on money borrowed for five years starting in 2021, implies inflation of only 1.47%, on average, through the next ten years.
Clearly, expectations are vanishingly low, but do they reflect what inflation will actually be in the future? At this point, it’s obligatory to say that no one actually knows, but in a recent economics piece, Strategas Research Partners, a strategy consulting firm, notes that, by breaking out goods and services inflation from the PCE, two useful relationships point to the potential for near-term bumps in U.S. inflation. Goods inflation, which has been negative recently due to commodity price declines, is currently rebounding as oil prices stabilize. However, this potentiality could be offset if oil prices decline anew. Relatively stable services inflation has been near 2% for the past five years, but it is inversely related to the national rental vacancy rate, which over the past twelve months has hit lows not seen since the mid-eighties. In addition, wage growth, as measured by the Atlanta Fed, has trended above GDP growth for several quarters. If these trends continue, they could lead to higher inflation and perhaps a painful spike in yields.
Although inflation like that of the 1970s is now a distant memory and likely won’t be returning soon, it wouldn’t take a beast like the one Paul Volker slew to spook the market – its greatly diminished specter might do the trick. While no one knows when or if such an event will occur, trends in the labor market, housing, and commodities could stoke inflation, however briefly, and investors could benefit from ensuring their portfolio has at least some hedge against it.
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