Thanos Bardas, head of Global Rates and Inflation Strategies at Neuberger Berman considers how various metrics are pointing to a turnaround in US inflation expectations.
Inflation hasn’t been on investors’ radar in recent years, as developed markets have tended to grapple more with the threats of slow growth and deflation, particularly in Europe and Japan.
US core inflation has been below the Federal Reserve’s 2% target for 33 consecutive months through April—not exactly a threat to pricing power.
Now, however, we are seeing signs that US inflation is becoming more important to investors, which we believe merits consideration in fixed income portfolios.
Treasury Yields: Reversal of Fortune
In 2014, deflationary fears were stoked by declining oil prices, moderating global growth and the strengthening US dollar.
Indeed, by year-end, nearly 14% of the securities in the Barclays Global Treasury Index were providing negative yields, reflecting pricing trends and the impact of aggressive global easing.
This environment triggered a then-surprisingly flattening of the US yield curve, with the difference between five-year and 30-year Treasuries narrowing by 113 basis points (bps) to bottom at 102 bps as of 6 January 2015.
Since then, however, the trend has been sharply upward, with the spread widening to 132 bps through 30 April.
Triggers: Oil, Policy and Employment
“The triggers of “reflation” psychology are multiple, in our view, including a rebound in oil prices, loose monetary policy and improving employment data:
• WTI oil prices have recovered nearly 40% from a 17 March low of $43. And the shape of the crude oil futures curve has flattened as front-end crude futures have risen significantly.
• The European Central Bank’s sizable quantitative easing program is designed to encourage eurozone inflation, while the Fed is flirting with a delay of its initial rate increase, which would also tend to help growth and stoke inflation prospects in the US.
• US unemployment declined to 5.4% in April—the lowest level since 2008. It’s also nearing the non-accelerating inflation rate of unemployment, or NAIRU (the level of unemployment below which inflation has tended to rise), which could contribute to wage pressures.
One indication of potential wage inflation comes from the small business sector survey conducted by the National Federation of Independent Business (NFIB), which asks business owners about their expectations for hourly wages.
Plotting these results against the Employment Cost Index suggests that there could be wage increases in the coming month.
US unit labor costs have already risen from post-recession lows, implying to us that core CPI should begin to trend upward as well.
Increased Demand for Inflation Protection
The potential for an uptick in inflation hasn’t been lost on investors, as evidenced by increased demand for TIPS (Treasury Inflation Protected Securities) this year.
Thus far in 2015, investors have purchased 72% of all auctioned TIPS, which is the highest level since at least 2003, while more flows have been moving into ETFs that invest in TIPS (about $611 million prior to the April Consumer Price Index report).
These trends have been viewed by the market as a large bet on an upside surprise in inflation in the coming months. Not surprisingly, TIPS breakevens have risen sharply since their trough in 2014.
Taking Proactive Steps
US inflation remains modest to be sure. Still, we believe the seeds for an uptick have been planted, and that further shifts in inflation expectations, when they arrive, could be felt quickly.
In such an environment, we feel investors should be considering ways to manage inflation in their portfolios, whether through TIPS, or other assets such as commodities, lower-rated debt, master limited partnerships, real estate investment trusts and or certain equity sectors, which have tended to hold up better than traditional bonds in inflationary periods.