Economic growth is picking up as the vaccine rollout gains speed, commodity prices are heading higher, the government is proposing another large fiscal aid package, and the Federal Reserve is pledging to keep its very easy monetary policy intact for the foreseeable future.
Not surprisingly, inflation expectations are rising, as illustrated in the chart below. Given these factors, how concerned should bond investors be about inflation? Here’s our take on the current situation, and what investors can consider doing now.
Investors have been paying up for inflation protection
Note: This is the 5-year, 5-year USD inflation swap rate. This rate is a common measure, which is used by central banks and dealers, to look at the market’s future inflation expectations. The rate is calculated using the following formula: USD: 2*USSWIT10 Curncy – USSWIT5 Curncy
Source: Bloomberg. USD Inflation Swap Forward 5Y5Y (FWISUS55 Index). Daily data as of 2/8/2020.
There are many ways to measure inflation. The most widely used measure is the Consumer Price Index (CPI). It captures price changes for a broad basket of goods and services. It’s the measure used for cost-of-living adjustments in many employment contracts and for Social Security payments. The benchmark measure used by the Federal Reserve is the deflator for personal consumption expenditures, or PCE. While policymakers follow a range of indicators, the PCE excluding the volatile food and energy components (core PCE) is the one most often referenced by the Fed.
Currently, the inflation picture looks tame, with most indicators remaining below the Federal Reserve’s 2% target, despite the differences in their compositions and the methodologies used to calculate them. In fact, inflation has averaged less than 2% since the end of the financial crisis in 2009 and the core PCE has barely budged above 2% for more than a few months at a time.
Core CPI and core PCE both have averaged below 2% since the financial crisis
Source: Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average and Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index), Percent Change from Year Ago, Monthly, Seasonally Adjusted. Monthly data as of 12/31/2020.
Inflation is most easily defined as a broad-based rise in prices. One-off price increases, such as a jump in oil prices, aren’t always enough to generate a sustained inflationary trend. While consumers spending a large proportion of their budgets on higher education or health care may experience higher inflation than other consumers, these inflation indicators attempt to capture broad average price changes across the economy.
Generating inflation usually requires demand outstripping supply in the economy, or “too much money chasing too few goods.” When the demand for goods and services is greater than the economy’s capacity to provide them, prices will rise. This relationship is often depicted as the “output gap,” or the difference between the country’s actual growth rate and its potential growth rate. The Federal Reserve may use it to assess the need for tighter or easier monetary policy. (It should be noted that “potential GDP” is an estimate based on many factors, including productivity and the growth rate in the labor force.)
GDP is running below potential, suggesting inflation is not a near-term threat
Source: U.S. Bureau of Economic Analysis, Gross Domestic Product (GDP) and U.S. Congressional Budget Office. Nominal Potential Gross Domestic Product (NGDPPOT), Gross Domestic Product, and the Gross Domestic Product Forecast. Quarterly data as of Q4-2020.
In the years following the financial crisis, the GDP growth rate was well below its potential and inflation remained tame. When the gap closed in 2015, the Fed began raising short-term interest rates in anticipation of higher inflation. However, inflation remained tame.
With the onset of the pandemic early last year, GDP growth fell steeply, causing the gap to open up again. In response, the Fed cut short-term interest rates to near zero. With ample fiscal and monetary stimulus, the size of the gap has shrunk, but it is still far from closing. There is still a lot of excess productive capacity as many businesses await stronger demand. Moreover, there is a large excess supply of labor in industries hit by the pandemic. There are close to 10 million fewer jobs now than at the beginning of 2020.
Consequently, the Fed is indicating it won’t raise interest rates until it sees lower unemployment. It is taking a “wait-and-see” approach to raising interest rates, rather than moving pre-emptively against inflation. The preconditions for rate hikes are low unemployment near or below 4% and higher inflation. Most importantly, the Fed is signaling that it is willing to allow inflation to overshoot its target for a “period of time” to allow the unemployment rate to fall further. Having overestimated the inflation threat for more than a decade, the Fed is inclined to wait for it to show up before acting.
Short- and medium-term prospects
We expect to see an uptick in inflation over the next few months, but it’s likely to be fleeting. Most of the increase we are looking for is due to comparing today’s prices to last year’s steep drop in the spring. On a year-over-year basis, inflation will likely tick higher. However, getting inflation to hold sustainably above the Fed’s 2% target for core PCE likely will take another year or two, considering the large output gap.
However, when we look a few years down the road, the case for a move up in inflation grows stronger. The Fed’s easy monetary policy stance—when combined with the prospect for another round of fiscal relief of about $1 trillion igniting stronger demand, and a rebound in the economy as the vaccine rollout proceeds—could lay the groundwork for higher average inflation than we’ve experienced for the past decade.
To be clear, we aren’t anticipating a return to 1970s-style inflation. That was a unique event in modern history, driven by a change in the structure of exchange rates, demographics, oil price shocks, expansive fiscal policies, as well as monetary policy errors. However, there are signs that some of the factors keeping inflation very low are abating. A sustained move back to the 2% to 3% range would represent a significant change from where inflation has been over the past 10 years.
Secular trends in inflation
Source: Bloomberg, using monthly data as of 1/31/2021. US CPI Urban Consumers YoY NSA (CPI YOY Index).
Demographics, deglobalization, the dollar and deficits
Demographic trends have contributed to the low-inflation story of the past few decades. As populations age, demand for goods and services tends to slow, resulting in lower GDP growth and lower inflation. The demographic “age wave” often cited to illustrate this relationship looks at the ratio of young to middle-aged workers. When the rate of growth in young workers is rising relative to the middle-aged and older workers, growth and inflation tend to rise. Younger people are in their “spending years”—forming households, buying home, appliances, autos, etc.—driving up consumption. In contrast, middle-aged workers tend to save more.
While the aging and retirement of the baby boom generation is still a potential overhang on growth and inflation, the ratio of young to middle-aged workers has been rising for a few years. That should mean stronger aggregate demand, all else being equal. Of course, all else is never really equal, and it looks like the financial crisis and the pandemic may have tempered demand from younger workers, but the trend suggests that much of the pressure on inflation from demographics may have run its course.
The ratio of young to middle-aged workers has risen in recent years
Source: Bloomberg and Organisation for Economic Co-Operation and Development (OECD). 10-year Treasury yield (USGG10 Index) and U.S. Consumer Price Index Ex Food and Energy “Core CPI” (CPI XYOY Index), annual averages through 12/2020. OECD historical population data and projections, annual averages, projections 2015-2025. “Young” is represented by the 25-to 34-year old cohort and “Middle Aged” is represented by the 45- to 54-year old cohort. Past performance is no guarantee of future results.
Downward pressure on wages likely has also contributed to the low-inflation environment. Several factors including globalization, the declining trend in unionization, and technological advancement likely have accounted for slow wage growth for a large group of workers. Labor’s share of overall GDP has been falling for many years, a trend that translates into less spending power for consumers. While it’s far from certain, a case can be made that this trend may also have run its course. The opening up of Eastern Europe to the world economy after the fall of the Berlin Wall in 1989, and China joining the World Trade Organization in 2001, added large numbers of workers to the global economy at low wages. Even absent policies that suggest “deglobalization,” it seems very unlikely that the global labor supply increase of the 1990-2020 era will be repeated.
The downtrend in the dollar, if it is sustained, is also potentially supportive to rising inflation. A weaker currency tends to raise inflation by pushing up the cost of imports and to boost growth by making exported goods more competitive. On a trade-weighted basis, the dollar had been rising for about 10 years until last spring when the Fed shifted to its very easy policy stance. We expect it to continue moving lower as a result of the decline in real interest rates in the U.S. and rising external deficits that need to be financed with foreign capital. A weaker currency should provide some support for higher growth and inflation.
The value of the U.S. dollar has trended downward in recent years
Source: Bloomberg. Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 2/5/2021. Past performance is no guarantee of future results.
What should investors consider now?
Here are a few steps you can take if inflation rises modestly, as we expect:
1. Keep average duration low. When it comes to investing in bonds in an environment of rising inflation, it is important to keep an eye on portfolio duration, or the sensitivity to rising interest rates. We suggest keeping the average duration in your portfolio below average, or below the benchmark, to mitigate the risk of rising interest rates.
2. Consider TIPS. Historically, Treasury bills have tended to keep up with inflation because they have such short maturities and can be rolled over frequently as the Fed hikes short-term interest rates. However, with the Fed indicating it will keep short-term rates near zero even as inflation rises, investors may want to consider shifting some Treasury holdings into Treasury Inflation-Protected Securities (TIPS), which are designed to keep pace with inflation. TIPS have a fixed coupon rate, but receive an adjustment to the principal amount based on the inflation rate. Although the coupon rate remains fixed, the coupon payment rises with the rise in the principal. This provides the benefit of an income stream linked directly to inflation and the potential for more principal at maturity in a rising inflation environment.
3. Add more yield when appropriate. Because we don’t anticipate very high inflation, we suggest using periods of rising yields to add medium- to long-term bonds over the next few years to generate more income in portfolios. In past rising-rate cycles, long-term rates typically moved up before short-term rates, causing the yield curve to steepen until rates approach the expected peak in the federal funds rate. As the Fed begins to tighten policy by raising short-term interest rates, the yield gap narrows, and the yield curve flattens. Because long-term rates represent the average of short-term rates plus a risk premium (term premium), short and long-term yields tend to converge at market peaks. Often, investors wait too long to add more yield to portfolios. As a result, they can end up missing the opportunity to lock in those higher coupons. We suggest strategies like bond ladders or barbells (which divides the allocation between short- and intermediate-term bonds) to help “average in” to higher yields over time. Bond ladders are particularly useful because they help balance the desire for income today with tendency to want to time the market.
Looking across the fixed income market, it is important to understand how different sub-asset classes have performed in both low and high inflationary time periods. As the chart below shows, Treasury bills tend to perform well during high inflationary periods because maturities are shorter and the yields rise when the Federal Reserve hikes rates. Conversely, when inflation doesn’t materialize and the Fed doesn’t see a need to hike rates, Treasury bills offer little upside in yield. This is another reason why we like bond ladders and barbells: The investor doesn’t “miss out” if inflation doesn’t come to fruition.
Returns in high- and low-inflation periods
Note: Each return listed is for the full time period available for each of the asset class indices shown.
Source: Bloomberg and Morningstar. S&P GSCI Index (S&P 500), Gold Dollar Spot (Gold), ICE BofA U.S. Mortgage Backed Securities Index (Mortgage Backed Securities), Bloomberg Barclays U.S. Aggregate Bond Index (Core Bonds), Bloomberg Barclays U.S. Short Treasury Index (Treasuries <1 year), Bloomberg Barclays U.S. Aggregate Corporate Bond Index (Investment Grade Credit), ICE BofA U.S. Municipal Securities Index (Munis), Bloomberg Barclays U.S. Corporate High Yield Bond Index (High Yield Credit), and Ibbotson Associates SBBI U.S. Long-Term Government TR (Long-term Treasuries), RBC Enhanced Commodity Index (Commodities). Monthly data from January 1960 to January 2021. Monthly data from January 1960 to January 2021. Past performance is no guarantee of future results.
Another way to think about the problem of where to invest in an inflationary environment is through an outperformance lens. In many cases, by taking on more risk, you earn a higher yield that stands a better chance at outperforming inflation. For instance, in corporate credit, coupons and yields are higher to compensate for default risk. If you are willing and able to take on that additional risk, then you can potentially outperform inflation.
However, we should note that despite current low yields and the risk of higher inflation, there are still good reasons to hold some Treasuries in a portfolio. They provide diversification from stocks, tend to dampen portfolio volatility and preserve capital.
Simoa L. Santiago, Senior Manager, Fixed Income Strategy, contributed to this report.