- The concept of allowing inflation to overshoot in the future to make up for past misses has surfaced recently in the U.S.
- Higher U.S. price pressures could impact long‑dated bonds and cause the curve to steepen.
- By contrast, low inflation in the Asia region remains supportive for local bond markets.
After more than a decade of low inflation in most developed market economies, it has been suggested in the U.S. that price rises should be allowed to overshoot in the future to make up for missing past targets. During our latest policy week meetings, the investment team discussed the potential implications of this for fixed income markets.
Allowing inflation to drift higher has been a dangerous approach for central banks in the past and has sometimes been associated with an exodus of foreign capital, particularly for emerging market countries. “History shows that central banks can quickly lose credibility when they let inflation run above target,” said Quentin Fitzsimmons, a portfolio manager and member of the global fixed income investment team.
U.S. policymakers are concerned about the implications of persistent low inflation expectations, leading to speculation that the Federal Reserve could make changes to the way it targets inflation. It could, for example, shift to an “average rate” target through which periods of above‑target price rises are tolerated in order to counterbalance below‑target periods.
In bond markets, long‑maturity bonds typically lose value, and the curve steepens when central banks are more lenient with their price targets. “In the scenario of higher U.S. inflation and an accommodative Fed, the front end of the curve is likely to remain anchored while long‑dated securities could come under pressure,” noted Mr. Fitzsimmons. Greater price pressures could provide a further boost to the U.S. inflation‑linked bond market, which has already been performing strongly, thanks to supportive seasonality factors and expectations that the Fed will remain on hold for at least the first half of 2019.
Discussions about the future inflation target come at a time when price pressures in the U.S. are expected to moderately grind higher as the output gap narrows. In credit markets, security selection will be important if U.S. inflation picks up steam, because margins could face pressure from higher production costs and lower capital spending—factors that could also lead to rating downgrades.
The investment team noted that industrial companies are most at risk, but theirs is not the only vulnerable sector. Service industries, for example, could also suffer, particularly as companies already face pressure from rising wage costs, as highlighted by the biggest annual increase in average hourly earnings since 2009 in February. “It makes sense to concentrate credit risk in the short end of the curve currently, and to shift some of the credit risk out of the U.S. back into the eurozone,” said Mr. Fitzsimmons.
Inflation remains subdued in the eurozone, supporting the European Central Bank’s decision to provide another round of cheap funding for banks. A lack of price pressures is also evident in other countries, most notably in Asia. “While inflation risk appears to be skewed to the upside in the U.S., Asia and Europe face the opposite side of the story with a lot of deflationary trends in place,” noted Mr. Fitzsimmons.
In terms of investment opportunities, local bond markets in Asia look attractive on a currency‑hedged basis. The combination of subdued inflation and a softer Fed policy potentially open the door for some countries to deliver interest rate cuts later this year. Indonesia, in particular, stands out in this regard as the prospect of lower food prices and contained oil prices should drive inflation lower there. In other emerging countries, the investment team noted that Mexico is an appealing local bond story as headline inflation is finally starting to break below 4% on the back of lower energy and agricultural prices. “It’s possible that Mexico’s central bank kicks off a rate‑cutting cycle that results in the key rate falling by as much as 150 basis points from the current 8.25% level,” said Mr. Fitzsimmons.
(Fig. 1) U.S. Inflation: A Tale Of Two Stories
U.S. employment cost vs. U.S.consumer price index, year on year change
As of February 28, 2019
Source: Bureau of Labor Statistics. Analysis by T. Rowe Price.
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.
Australia—Issued in Australia by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 50, Governor Phillip Tower, 1 Farrer Place, Suite 50B, Sydney, NSW 2000, Australia. For Wholesale Clients only.
Brunei—This material can only be delivered to certain specific institutional investors for informational purpose upon request only. The strategy and/or any products associated with the strategy has not been authorised for distribution in Brunei. No distribution of this material to any member of the public in Brunei is permitted.
Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.
China—This material is provided to specific qualified domestic institutional investor or sovereign wealth fund on a one-on-one basis. No invitation to offer, or offer for, or sale of, the shares will be made in the People’s Republic of China (“PRC”) (which, for such purpose, does not include the Hong Kong or Macau Special Administrative Regions or Taiwan) or by any means that would be deemed public under the laws of the PRC. The information relating to the strategy contained in this material has not been submitted to or approved by the China Securities Regulatory Commission or any other relevant governmental authority in the PRC. The strategy and/or any product associated with the strategy may only be offered or sold to investors in the PRC that are expressly authorized under the laws and regulations of the PRC to buy and sell securities denominated in a currency other than the Renminbi (or RMB), which is the official currency of the PRC. Potential investors who are resident in the PRC are responsible for obtaining the required approvals from all relevant government authorities in the PRC, including, but not limited to, the State Administration of Foreign Exchange, before purchasing the shares. This document further does not constitute any securities or investment advice to citizens of the PRC, or nationals with permanent residence in the PRC, or to any corporation, partnership, or other entity incorporated or established in the PRC.
DIFC—Issued in the Dubai International Financial Centre by T. Rowe Price International Ltd. This material is communicated on behalf of T. Rowe Price International Ltd. by its representative office which is regulated by the Dubai Financial Services Authority. For Professional Clients only.
EEA ex-UK—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.
Hong Kong—Issued in Hong Kong by T. Rowe Price Hong Kong Limited, 21/F, Jardine House, 1 Connaught Place, Central, Hong Kong. T. Rowe Price Hong Kong Limited is licensed and regulated by the Securities & Futures Commission. For Professional Investors only.
Indonesia—This material is intended to be used only by the designated recipient to whom T. Rowe Price delivered; it is for institutional use only. Under no circumstances should the material, in whole or in part, be copied, redistributed or shared, in any medium, without prior written consent from T. Rowe Price. No distribution of this material to members of the public in any jurisdiction is permitted.
Korea—This material is intended only to Qualified Professional Investors upon specific and unsolicited request and may not be reproduced in whole or in part nor can they be transmitted to any other person in the Republic of Korea.
Malaysia—This material can only be delivered to specific institutional investor upon specific and unsolicited request. The strategy and/or any products associated with the strategy has not been authorised for distribution in Malaysia. This material is solely for institutional use and for informational purposes only. This material does not provide investment advice or an offering to make, or an inducement or attempted inducement of any person to enter into or to offer to enter into, an agreement for or with a view to acquiring, disposing of, subscribing for or underwriting securities. Nothing in this material shall be considered a making available of, solicitation to buy, an offering for subscription or purchase or an invitation to subscribe for or purchase any securities, or any other product or service, to any person in any jurisdiction where such offer, solicitation, purchase or sale would be unlawful under the laws of Malaysia.
New Zealand—Issued in New Zealand by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 50, Governor Phillip Tower, 1 Farrer Place, Suite 50B, Sydney, NSW 2000, Australia. No Interests are offered to the public. Accordingly, the Interests may not, directly or indirectly, be offered, sold or delivered in New Zealand, nor may any offering document or advertisement in relation to any offer of the Interests be distributed in New Zealand, other than in circumstances where there is no contravention of the Financial Markets Conduct Act 2013.
Philippines—THE STRATEGY AND/ OR ANY SECURITIES ASSOCIATED WITH THE STRATEGY BEING OFFERED OR SOLD HEREIN HAVE NOT BEEN REGISTERED WITH THE SECURITIES AND EXCHANGE COMMISSION UNDER THE SECURITIES REGULATION CODE. ANY FUTURE OFFER OR SALE OF THE STRATEGY AND/ OR ANY SECURITIES IS SUBJECT TO REGISTRATION REQUIREMENTS UNDER THE CODE, UNLESS SUCH OFFER OR SALE QUALIFIES AS AN EXEMPT TRANSACTION.
Singapore—Issued in Singapore by T. Rowe Price Singapore Private Ltd., No. 501 Orchard Rd, #10-02 Wheelock Place, Singapore 238880. T. Rowe Price Singapore Private Ltd. is licensed and regulated by the Monetary Authority of Singapore. For Institutional and Accredited Investors only.
Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.
Taiwan—This does not provide investment advice or recommendations. Nothing in this material shall be considered a solicitation to buy, or an offer to sell, a security, or any other product or service, to any person in the Republic of China.
Thailand—This material has not been and will not be filed with or approved by the Securities Exchange Commission of Thailand or any other regulatory authority in Thailand. The material is provided solely to “institutional investors” as defined under relevant Thai laws and regulations. No distribution of this material to any member of the public in Thailand is permitted. Nothing in this material shall be considered a provision of service, or a solicitation to buy, or an offer to sell, a security, or any other product or service, to any person where such provision, offer, solicitation, purchase or sale would be unlawful under relevant Thai laws and regulations.
UK—This material is issued and approved by T. Rowe Price International Ltd, 60 Queen Victoria Street, London, EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.
© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.