US debt investors seek protection against inflation
Investors are piling in to US inflation-linked bonds, as the Federal Reserve embraces the idea of letting consumer price-rises run above target to avoid the sluggishness that has dogged much of Europe and Japan.
In the minutes from December’s policy-setting meeting, Fed officials signalled a willingness to keep interest rates steady until there is a pick-up in inflation, which has remained below the central bank’s 2 per cent target despite a series of interest rate cuts in 2019.
The Fed is also close to wrapping up a once-in-a-decade review of its monetary policy toolkit, launched by chairman Jay Powell, in which it is considering introducing a “make-up strategy” for inflation — a promise to temporarily raise the inflation target after periods of undershooting.
Inflation is typically a trigger for investors to step back from standard government bonds. The interest payments on those bonds are fixed, so higher inflation eats away at the value they promise for the future. Now, bonds are not weakening, supported in part by the latest outbreak of geopolitical stress. But Treasury inflation-protected securities, or Tips, are climbing, reflecting a thirst among fund managers for instruments that are indexed to inflation and that provide a hedge for times when inflation takes hold.
Big investment firms including Pimco, BlackRock and Franklin Templeton are among those that have been snapping up the inflation-linked bonds.
“The notion that inflation is gone is a heroic assumption,” said Sonal Desai, chief investment officer at Franklin Templeton Fixed Income Group. Tips offer value, she said, because market participants are “too sanguine” about price rises.
The 10-year break-even inflation rate, a market measure of inflation expectations derived from Tips, now sits at 1.78 per cent, up from a low of 1.47 per cent in October. Meanwhile, the “five-year five-year” swap rate, which measures what five-year inflation expectations will be in five years’ time, hovers around 1.8 per cent.
While still below the Fed’s target, both are higher than its favourite inflation gauge, core PCE, which dropped to 1.6 per cent last month on a year-over-year basis, having finished 2018 closer to 1.8 per cent. The index measures the prices paid by people for domestic purchases of goods and services, excluding the cost of food and energy.
Dan Ivascyn, group chief investment officer at Pimco, which oversees nearly $1.9tn of assets, said he likes Tips because break-even rates look low and he sees the potential for “sustained inflation pressure” as fiscal measures become the preferred tool to shore up growth. He added that he has a “slightly positive” view on oil — a trend that could gain momentum, pushing up prices, given the recent escalation in US-Iran tensions.
Last year, investors largely shunned Tips and similar instruments. Flows into exchange traded funds that buy inflation-linked assets accounted for about 1 per cent of a total $260bn of inflows into fixed-income ETFs, according to Antoine Lesné of State Street Global Advisors.
That could change, said Rick Rieder, BlackRock’s chief investment officer of global fixed-income, not only because the Fed is encouraging prices to move higher but also because the growth outlook will stay positive.
“The economy is much more stable than people think,” he said. “It will be really hard for the consumer to stumble next year unless there is a big exogenous shock.”
Renewed offensives in the US-China trade war could bring about that shock, he added.
However, he added that even then, inflation is unlikely to blow through the Fed’s target, given that “technological headwinds” continue to push prices down. “I don’t think it will ever run hot,” he said.