More Supportive Backdrop for Inflation-Linked Debt Despite HeadwindsJune 14, 2018
- U.S. inflation has normalized, with the consumer price index rising and breakevens at multiyear high levels as the Federal Reserve continues down the path of gradual tightening of policy rates.
- The Fed has noted inflation's rise and become more confident about its path of tightening policy rates, which may counter a further increase in TIPS breakevens; the central bank could be more likely to react if inflation rises with additional tightening measures.
- Some upside risk remains in TIPS breakevens, particularly if oil prices remain elevated, but it is important to remember that the secular forces of technology and demographics remain in place—keeping the prospect for runaway inflation at bay.
- With oil prices rising steadily since last June, inflation-linked debt in Europe has reacted in a similar fashion to U.S. TIPS.
As the Federal Reserve continues down the path of gradual tightening of policy rates, U.S. inflation has normalized, with the consumer price index (CPI) rising and breakevens at multiyear high levels. Breakevens, which measure market inflation expectations, are the difference between nominal and real yields for a given maturity. While the potential for inflation accelerating further is limited, modest upside risks remain, which could translate into opportunities in U.S. Treasury inflation protected securities (TIPS) and inflation-linked debt in other developed markets.
HIGHER INFLATION REPRESENTS A NORMALIZATION
In mid-May, the U.S. 10-year inflation break-even rate hit its highest level in four years—signaling improving inflation expectations and growing optimism surrounding domestic economic growth. Among the drivers behind this move higher in breakevens, two of the most significant have been fundamental in nature—the rise and renormalization in core CPI and the increase in oil prices. Core inflation troughed in 2017 and has accelerated over the past six to nine months. At the same time, oil prices rose by about 50% over the last 12 months. While market sentiment has moved from deflation fear in mid-2017 to inflation fear in early 2018, the reality of the situation likely lies somewhere in between.
This recent acceleration in inflation from its 2017 lows has been more akin to a renormalization, coinciding with Fed interest rate hikes, and the prospect for further acceleration from here is somewhat limited by a few factors. For one, continuing monetary policy tightening from the Fed is all but certain as the central bank has been open and transparent about the future path of interest rate hikes. Additionally, shelter prices, which are a large part of CPI, have stabilized at a high level, and the components of inflation largely tied to tightening labor markets have not responded as expected—wage increases from tighter labor markets have been modest and have only moderately contributed to higher inflation.
INFLATION EXPECTATIONS RISE BUT ARE DAMPENED LONG TERM BY FED TIGHTENING
Meanwhile, the Fed has noted inflation’s rise and become more confident about its path of tightening policy rates, which may counter a further increase in TIPS breakevens. The Fed could be more likely to react if inflation rises with additional tightening measures.
The relatively flat TIPS break-even curve demonstrates this dynamic between fundamental drivers pushing inflation upward and the Fed acting as a counterweight. U.S. inflation-linked debt at the front end of the curve is trading at similar levels to longer-dated TIPS. Current inflation and rising oil prices affect the short end of the curve, while the long end is more influenced by the Fed’s reaction to inflation and the central bank’s credibility on controlling inflation. As such, the flat TIPS break-even curve is a function of current inflation pushing breakevens higher mixed with the market’s belief that the Fed will continue its gradual tightening and work to keep inflation near its target.
MODEST UPSIDE POTENTIAL REMAINS FOR INFLATION DESPITE HEADWINDS
We expect core CPI to print somewhere in the 2.25% to 2.50% range throughout 2018. Traditionally, breakevens would be at or above the current level of core inflation, but the current break-even curve is not reflecting this historically typical behavior. Additionally, breakevens have not overreacted to the spike in energy prices. Some upside risk remains in TIPS breakevens, particularly if oil prices remain elevated, as the rise in inflation has been cyclical. However, it is important to remember that the secular forces of technology and demographics remain in place—keeping the prospect for runaway inflation at bay.
EUROPEAN BREAKEVENS ACTING SIMILARLY
With oil prices rising steadily since last June, inflation-linked debt in Europe has reacted in a similar fashion to U.S. TIPS. As shown in Figure 1, which charts five-year breakevens in the U.S., France, and the UK along with the price of Brent crude oil, French breakevens have trended upward along with oil’s rise. Notably, however, overall inflation is considerably lower in France, and the European Central Bank is still taking an accommodative stance while the Fed is tightening.
In contrast, breakevens in the United Kingdom seem less responsive. The inflation pass-through effects have waned from the pound sterling’s depreciation after the June 2016 Brexit vote as this time period has rolled out of the headline retail prices index data point used by the UK government. This fact is partly responsible for the diminished impact of higher oil prices on UK breakevens.
May 31, 2008–May 31, 2018
Sources: High Yield Corporate—J.P. Morgan Global High Yield Index, EM Debt Dollar—J.P. Morgan Emerging Markets Bond Index Global, U.S. Corporate Investment Grade—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index.*
Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright 2018, Bloomberg Index Services Ltd. Used with permission.
Yield spreads over Treasuries are the calculated spreads between a computed option-adjusted spread index of all bonds in a given rating category and a spot Treasury curve.
*Option-adjusted spread for the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index as of May 31, 2018. Spread-to-worst for the J.P. Morgan Global High Yield Index as of May 31, 2018.
(As of May 31, 2018)**
Past performance is not a reliable indicator of future performance.
Sources: T. Rowe Price, Bloomberg Barclays, J.P. Morgan, and S&P/LSTA.
**U.S. Treasuries—Bloomberg Barclays U.S. Treasury Index, U.S. TIPS—Bloomberg Barclays U.S. TIPS Index, Global Sovereign ex-U.S.—Bloomberg Barclays Global Aggregate ex-U.S. Index, U.S. Municipals—Bloomberg Barclays Municipal Bond Index, MBS—Bloomberg Barclays U.S. MBS Index, CMBS—Bloomberg Barclays U.S. CMBS Index: ERISA Eligible, ABS—Bloomberg Barclays Asset Backed Index, Global Investment-Grade Corporate—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index, Global High Yield Corporate—J.P. Morgan Global High Yield Index, Bank Loans—S&P/LSTA Performing Loans Index, EM Dollar Sovereigns—J.P. Morgan Emerging Markets Bond Index Global, EM Corporates—J.P. Morgan CEMBI Broad Diversified, EM Local—J.P. Morgan Global Bond Index—Emerging Market Global Diversified.
†European corporates are included in this sector.
TIPS (Treasury Inflation Protected Securities) are Treasury bonds that are adjusted to eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index (CPI). When inflation is negative or concerns over inflation are low, the value of these securities could fall, resulting in losses.
Key Risks—As interest rates rise, bond prices generally fall. Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates, which may affect the value of an investment. Returns can be more volatile than other, more developed markets due to changes in market, political, and economic conditions. Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default, which may affect the value of an investment. Investments in high yield securities involve a higher element of risk. Companies issuing leveraged loans typically have a below investment-grade credit rating, and the loans could have greater price declines than higher-rated bonds.
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