US bond investors seek inflation protection
Investors are flocking to U.S. inflation-linked bonds as the Federal Reserve embraces the idea of letting consumer price increases run above target to head off the gloom gripping much of Europe and Japan.
In the minutes of the December policy-making meeting, Fed officials signaled their desire to keep interest rates stable until there is a pick-up in inflation. , which remained below the central bank’s 2% target despite a series of interest rate cuts in 2019.
The Fed is also set to wrap up a one-time review of its monetary policy toolkit, launched by Chairman Jay Powell, in which it plans to introduce a “catch-up strategy” for inflation – a promise to temporarily raise the inflation target after periods of undervaluation.
Inflation is usually a trigger for investors to move away from standard government bonds. The interest payments on these bonds are fixed, so higher inflation eats away at the value they promise for the future. Today, bonds are not weakening, supported in part by the latest outbreak of geopolitical tensions. But Treasury Inflation-Protected Securities, or Tips, are climbing, reflecting a hunger among fund managers for instruments that are inflation-linked and provide a hedge for times when inflation sets in.
Large investment companies such as Pimco, BlackRock and Franklin Templeton are among those that have bought 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. Tipping offers value, she said, because market participants are “too optimistic” about price increases.
The 10-year equilibrium inflation rate, a market measure of inflation expectations derived from the guidance, now stands at 1.78%, up from a low of 1.47% in October. Meanwhile, the “five-year-to-five-year” swap rate, which measures what five-year inflation expectations will be five years from now, is hovering around 1.8%.
While still below the Fed’s target, both are above its favorite inflation gauge, the core PCE, which fell to 1.6% last month on an annual basis, after ending 2018 closer to 1.8%. 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 $1.9 billion in assets, said he likes the advice because break-even rates look low and he sees potential for growth. ‘sustained inflationary pressure’ as fiscal measures become the preferred tool for consolidating growth. He added that he had a “mildly positive” view on oil – a trend that could accelerate, pushing prices higher, given the recent escalation in US-Iranian tensions.
Last year, investors largely shunned advice and similar instruments. Flows to exchange-traded funds that buy inflation-linked assets accounted for about 1% of a total of $260 billion in 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 for global fixed income, not only because the Fed is encouraging prices to rise, but also because the outlook for growth will remain 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.”
New offensives in the U.S.-China trade war could cause that clash, he added.
However, he added that even then, inflation is unlikely to exceed the Fed’s target, given that “technological headwinds” continue to drive prices lower. “I don’t think it will ever heat up,” he said.