By Thanos Bardas, Senior Portfolio Manager-Investment Grade Fixed Income
Prices for U.S. Treasury Inflation Protected Securities (TIPS) suggest inflation will be the same over the next 10 years as over the past five. We think that is too pessimistic.
Something is stirring in the inflation-protected securities markets. According to data provider Markit, a record $2.3 billion flowed into U.S. TIPS exchange traded funds during the first quarter of 2016.
Is U.S. Inflation "Stirring" or Just Volatile?
In mid-February, the 10-year break-even inflation rate hit a post-financial crisis low of around 1.2%. Since then, TIPS inflows have taken it up to 1.6%. Even so, we think bond markets are still underpricing long-term U.S. inflation risk, implying attractive value in TIPS.
Certainly, a range of measures of U.S. inflation have ticked up lately. Core CPI, which excludes volatile elements such as food and energy prices, is now running at 2.2%. Even the headline number, including the big fall in oil prices, is almost at 1%. Doubters point to the failure of near record-low unemployment to feed through into a meaningful pay rise for U.S. workers, however.
Bond Markets Are More Pessimistic About Long-Term Inflation than Other Forecasters
Bond markets are clearly among those doubters. There are other places to look for long-term inflation expectations, however, and they offer a revealing perspective.
The Philadelphia Fed Survey of Professional Forecasters' estimate of the 10-year CPI rate predicts an annualized rate of around 2.1%. The University of Michigan survey of consumers' median inflation expectations for the next five to 10 years remains above 3%. A relatively new benchmark, the Federal Reserve Bank of New York's survey of consumers' median inflation expectations over three years, predicts a rate of around 2.6%.
The 10-year market break-even rate at 1.6% is lower than all of these. In fact, it is at the same level as the trailing five-year average for headline CPI. In other words, the bond market is forecasting another decade of the low inflation we have seen over the past five years - a very cynical view of the Fed's capacity to stimulate the economy.
Of the two components of the CPI - the fast-moving energy and food prices and the slow-moving core components - it is the latter that bond markets have tended to correlate with more closely. The 10-year break-even rate and the realized core CPI rate have diverged, but they always converge again relatively quickly.
The Long-Term Bond Market Break-Even Inflation Rate Has Tended to Converge with Core CPI
Source: Bloomberg, Neuberger Berman. Data as at March 31, 2016.
Today's 1.6% 10-year break-even rate is closer to the headline CPI reading of 1.0% than the core reading of 2.3%. Moreover, the low headline number is a reflection of the fact that energy inflation is running at -13%, a year-over-year move that we are unlikely to see repeated over the next 12 months. Back in mid-2014, the 10-year break-even inflation was above the Fed's 2% target. Since then, however, bond markets have obsessed over two things. The first is oil and its slide from $100 to sub-$40 per barrel. The second is the U.S. dollar, up 20% over the same period.
Recent stabilization of both the oil and dollar trends has coincided with big inflows into TIPS investment products, but the fact that the 10-year break-even inflation rate still languishes at 1.6% suggests that markets are either finding it difficult to relinquish their oil and dollar fixation, or taking a severely pessimistic view of the economy and of central banks' powers to manage it.
Until they take a longer-term view again, U.S. TIPS will continue to offer compelling value potential.
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