Bond markets have taken the recent shift in the Federal Reserve’s policy framework in their stride, partly because interest rates are now expected to stay lower for even longer. But they look vulnerable if the Fed can revive inflation.
At the end of August, the Federal Reserve (Fed) relaxed its inflation objective as part of its latest effort to steer the US economy out of the coronavirus-induced recession. In an eagerly anticipated statement, the central bank said it will tolerate inflation “moderately above two per cent for some time” after periods of persistently low inflation.1 Chairman Jerome Powell called this strategy “a flexible form of average inflation targeting”.2
Although the announcement was seen in some quarters as heralding a potentially significant easing of monetary policy, it is unlikely to have major ramifications for bond markets in the immediate future; beyond cementing expectations interest rates will stay near zero for an extended period, possibly years.
Policymakers’ overriding concern in the short term is to sustain demand and avoid deflation
That is partly because the central bank failed to offer many clues as to how the new regime will operate. But more importantly, if the near record low rate of US unemployment seen throughout 2019 failed to provoke any meaningful upward pressure on prices, it is hard to see where inflation might come from now given the size of the demand shock placed on the economy by the pandemic. Policymakers’ overriding concern in the short term is to sustain demand and avoid deflation.
It may be true the cost of hedging against inflation has risen over the past six months. For instance, ten-year ‘break-evens’ – the yield differential between government bonds that protect against inflation and those that do not – have climbed steadily since hitting a multi-year low in March, as shown in Figure 1. By this yardstick, inflation is expected to average 1.7 per cent over the next decade, up from just 0.5 per cent in the spring.
Figure 1: US 10-year break-even inflation rate
However, it is unclear this rise in break-even rates had much, if anything, to do with the market anticipating the Fed’s policy shift. Rather, it appears to be more a reflection of the fact they had fallen too low at the height of the pandemic, particularly given the short-term constraints on the supply of various goods and services.
The Fed’s credibility problem
According to James McAlevey, Aviva Investors’ global head of rates, the Fed, like other central banks, has a credibility problem it needs to overcome before markets start pricing in much higher inflation.
“Just because it wants inflation above target and is prepared to leave it there - if it gets there - is no guarantee that will happen. How do you get an inflation overshoot in the first place?,” he says.
The yield on conventional ten-year Treasuries has risen only marginally
Ordinarily, the rebound in inflation expectations might have triggered a corresponding rise in nominal yields. However, this has not happened. The yield on conventional ten-year Treasuries has risen only marginally. At around 0.7 per cent, it remains close to its historic low. Instead, real yields have sunk ever deeper into negative territory.3
It seems the market is happy to buy into the idea that the Fed’s desire to peg short-term interest rates close to zero for an extended period will not fuel excessive inflation. Far from hampering its ability to keep a lid on yields at the long end of the curve, this is helping depress them as the search for yield continues, at least for now.
With investors content to believe record government debt issuance in the US, as elsewhere, will if necessary be absorbed by equally vast bond-buying programmes from central banks, the Fed has in recent weeks been able to scale back the size of its bond purchases. Having bought nearly $1.5 trillion of Treasuries between mid-March and mid-April, it is currently purchasing roughly $80 billion a month.4
So long as markets continue to question the ability of the Fed and other central banks to deliver a significant pick-up in inflation, even skyrocketing government deficits seem unlikely to trigger a big rise in yields.
The inflation threat
While this may be true in the short term, markets could be underestimating the danger of higher inflation over longer timeframes as the economic recovery gathers momentum. Several prominent commentators have already begun warning of the inflationary threat posed by the massive monetary stimulus being employed by central banks around the world.
In the decade that followed the GFC, most developed economies suffered persistently low inflation
Such warnings are nothing new of course. They were commonplace in the aftermath of the global financial crisis (GFC), yet in the decade that followed most developed economies suffered persistently low inflation. In the US, for instance, the consumer price index (CPI) rose by an average of just 1.75 per cent annually in the decade to the end of 2019. It was even lower in the euro area at 1.34 per cent.
There are a number of reasons to believe this time could be different. For a start, and unlike in 2009, commercial banks are not under pressure to shrink their balance sheets by reining in lending. On the contrary, with most seen to be adequately capitalised, authorities are encouraging them to extend loans to businesses and households to help alleviate financial difficulties.
Secondly, the deflationary environment created by ever-expanding Chinese exports and globalisation looks to be drawing to a close. That could mean rising wage pressures as and when labour markets get tight.
Thirdly, and perhaps most significantly, unlike in the post-GFC period, fiscal policy is now extremely loose. While it seems likely governments will eventually come under pressure to get deficits back under control, the kind of austerity policies that followed the GFC in a number of countries are not politically acceptable today. Pressuring central banks to permanently monetise a chunk of the debt could be a more palatable solution, all the more so should that policy be viewed as being likely to lead to inflation. After all, inflation would erode the value of the remainder of the debt not bought by central banks.
The Fed’s preferred measure of inflation is the personal consumption expenditures (PCE) price index, prepared by the Bureau of Economic Analysis. Since this index is constructed differently to CPI, which is produced by the Bureau of Labor Statistics, the two behave differently over time.
If inflation is picking up, inflation volatility is likely to rise too
In recent years, CPI inflation has been running approximately 0.4 points higher than the PCE measure. So if the Fed were to achieve average PCE inflation of two per cent over time, that would equate to CPI inflation of around 2.4 per cent.
With inflation swaps currently pricing in average CPI inflation of around 1.9 per cent over the next 30 years, there is room for the market to price in appreciably higher inflation should it start to believe the Fed will hit its target over the long term. Moreover, if inflation is picking up, inflation volatility is likely to rise too.
“In a world where inflation averages 2.4 per cent, but it’s only one per cent in one year and 3.8 per cent the next, you’re suddenly having to price in inflation of 2.5, 2.6, 2.7 per cent to account for the additional uncertainty. There’s still plenty of daylight between where the market is now and where it could be if the Fed can deliver what it is promising,” McAlevey says.
Nightmare on Wall Street
The nightmare scenario for bond investors would be one where inflation overshoots the Fed’s target, political pressure prevents policy from being tightened before inflation expectations have become entrenched, and supply starts to overwhelm the market.
While McAlevey describes such a scenario as “an absolute tail risk”, he says if the market starts to sniff inflation is getting out of control, bonds would be at risk of a “bloodbath”. In that scenario, the Fed, which already owns around 20 per cent of the Treasury market,5 would be forced to step in with significant further support.
Japan and Europe suggest there is technically no limit to the amount of debt a central bank can buy
The recent experiences of Japan and Europe suggest there is technically no limit to the amount of debt a central bank can buy. In Japan, the central bank owns over 40 per cent of the outstanding bonds issued by the government,6 while the European Central Bank mopped up 90 per cent of the €2.1 trillion of debt issued by European governments between March 2015 and December 2018.7
That said, buying up a massive chunk of the bond market at a time when the central bank is potentially running the economy hot, is an untried policy and potentially a toxic combination for bonds. For this reason, McAlevey believes yield-curve control would be a preferable intermediate step.
Even if the Fed’s move to average inflation targeting is unlikely to lead to the type of runaway inflation witnessed in the 1970s, just moderately higher inflation could be costly for bond investors. With yields at, or close to, record lows across maturities, a spike could wipe out a significant portion of returns.
McAlevey argues both break-evens and nominal yields still look too low if the Fed’s new inflation policy is seen to be credible. Since they are being poorly compensated for it, investors might be wise to find ways of protecting their portfolios against the threat of inflation, at least over longer horizons. He has been shortening the duration of his bond portfolios, although at this stage is not going as far as to anticipate a dramatic steepening of the yield curve given the Fed’s desire to avert a sharp rise in longer-dated yields.
“This is a slow-moving story for now, but I’d expect the curve to begin steepening well before the Fed began to run the economy hot for a protracted period. If the Fed is successful, it could easily become as steep as it’s been for 40 years,” he says.
EM investors need to be alert
Pricing in the threat of inflation may be a task with which developed market bond investors have become unaccustomed in recent years, but the same cannot be said for certain parts of the emerging market debt universe. While emerging market inflation rates in broad terms have converged towards those in developed nations in recent years, there have been notable exceptions. Inflation last year touched 50 per cent in Argentina and in 2018 hit 25 per cent in Turkey.8
With emerging nations adopting unprecedented monetary and fiscal stimulus, inflation concerns could resurface
While rising food prices due to COVID-19 has led to an increase in inflation in a number of countries such as Russia, Mexico and India more recently, as in the developed world there is not much sign of inflation taking root across emerging economies as a whole.
Liam Spillane, head of emerging market debt at Aviva Investors, believes the scale of liquidity being provided by global central banks will continue to overshadow such concerns. Indeed, in the short term he is more worried about the damage being inflicted on economies and in turn government finances by the pandemic. That means it is too early to be looking to protect portfolios against the threat of inflation.
But with emerging nations increasingly adopting monetary and fiscal stimulus on an unprecedented scale, concern about the inflationary impact of debt monetisation could resurface for the first time in more than two decades should the Fed and other central banks succeed in reflating the global economy.
“Since the US dollar is the world’s premier reserve currency, the Fed may be able to monetise a large amount of debt. But there’s much less scope, from a credibility perspective, for say Bank Indonesia or the South African Reserve Bank to get away with it,” Spillane explains.
He currently favours less volatile debt denominated in hard currencies. While he believes local currency debt might actually respond positively if the US market were to price in improved economic growth and moderately higher inflation, there is a limit to how much inflation investors would be prepared to tolerate.
“Should higher inflation lead to expectations of tighter policy and liquidity withdrawal, things could quickly become much less favourable,” he warns.
Rising duration means credit is no safe haven
For James Vokins, head of UK investment grade credit at Aviva Investors, while corporate bonds do not price in inflation other than indirectly via government bond yields, they remain vulnerable to turbulence in underlying government bond markets.
“Even if there is little danger in the near term, should the longer-term outlook for inflation deteriorate that could spell trouble, especially for investment grade issues that are far more sensitive to interest rates than high yield,” says Vokins.
The fact US companies have been buying back record amounts of debt with shorter maturities and higher coupons and issuing longer-dated debt to pay for it is adding to his concern.
Investing is inherently riskier at a time when fundamental credit risk is also higher
“The duration of bond indices is increasing. That means investing is inherently riskier at a time when fundamental credit risk is also higher,” Vokins says.
For now, however, he says the hunt for yield is so strong that it is hard seeing yields going up in a hurry, especially since the Fed’s new methodology will lead to even looser policy.
While it would be premature to bet heavily on a major shift in the inflation outlook at this time, much could yet depend on just how ‘flexible’ Powell’s new average inflation targeting regime proves to be.