The inflation debate rages on. Will inflation pick up amid vaccine rollouts, fiscal stimulus, accommodative monetary policy, and federal reserve quantitative easing (QE)? Or will inflation remain subdued amid “new normal” behavioral spending patterns, elevated unemployment, persistent debt matrixes, and the increasingly viable argument for the Japanification of U.S. economics (negative rates, massive QE, and fiscal stimulus, failing to prompt inflation for a decade)?
Both sides of the debate have precedent; however, the fundamentals point to reflationary tailwinds with a long-term case for inflation. In short, inflation remains in check “right now” as the inflation rate is expected to stay within 2% (or slightly more). The systemic effect of low rates on the macroeconomic environment and the Fed’s aggressive involvement in revitalizing economic growth has some drawbacks. However, what remains crucial to monitoring inflation is the accuracy of breakeven rates and other inflationary indicators. It can be argued that there is potential for distortions in inflation breakeven rates. The total number of Treasury Inflation Protection Securities (TIPS) falling as a percentage of nominal securities in circulation and the Fed’s increased holdings of the total TIPS in circulation can potentially exaggerate the recent rise in breakeven rates (a favorite indicator of inflationary expectations).
Additionally, near-term rising commodity prices and the “base effect” (by definition: the distortion in monthly inflation figures that result from abnormally high or low levels of inflation in the year-ago month) illustrate an unsustainable year-over-year change in inflation. This could lead to a temporary rise in inflation, eventually normalizing by 2022. Since the real unemployment rate is hovering around 10%, worrisome inflation remains in check until a fully employed labor force occurs.
How do you quantify inflation expectations?
Economic income and demand economics aside, the baseline to inflation fears can be easily explained by the traditional inflationary indicators. First, the boost to M1 supply driven by the Fed’s U.S. treasury/other security purchases and fiscal policy’s increased stimulus packages throughout the COVID economy appear disproportionate. M1 supply has increased approximately $3 trillion since the start of the pandemic, with more liquidity likely to grow from the Biden administration’s “American Rescue Plan” and the Fed’s continuous $120 billion monthly purchase of securities.
Despite monetary policy keeping short-term rates suppressed in the near-term and continued stimulus injections further increasing M1 supply, a bear steepening of the yield curve is likely (as described in Deciphering a COVID-19 Vaccine-Driven Economic Recovery: An Equity and Fixed Income Perspective). Historically, a “bear steepening” (widening of the yield curve caused by long-term rates increasing faster than short-term rates) situation suggests rising inflationary expectations. The increase in inflation can lead the Fed to increase interest rates to slow prices from rising too fast. In turn, investors who sell their existing fixed-rate long-term bonds as yields become less attractive in a rising rate environment can subsequentially depress prices on long-term bonds and damage returns for holders of these long-term bonds.
Even though some may argue the Fed’s influence on the TIPS market may “inflate” breakeven rates and the “base effect” may exaggerate YoY inflation data, it is crucial to keep in mind that the Fed’s interest rate policy remains supportive of a breakeven rate recovery (though it could be occurring faster than without Fed intervention).
What if breakeven rates are not what they seem?
From an alternative perspective, the relationship between real rates and gold, as explained in Gold Continues to Shine, also indicates inflationary expectations. As real rates turned negative, gold’s 0% interest rate becomes increasingly more attractive (as seen below). Therefore, gold’s divergence from real rates can be driven by a potential shift in U.S. Federal Reserve inflationary bias amid the current thematic backdrop.
What are negative real rates?
Negative real rates mean that the inflation rate is greater than the nominal interest rate. With both the 10-year US treasury rate offering approximately a -0.94% real yield and the 7-10-year US investment-grade corporate bonds offering a current real yield of -0.14% (ICE BofA 7-10 Year US Corporate Index Effective Yield of 2.10% minus Projected Inflation Rate in US for 2021 of 2.24%), the search for yield remains top of the investor’s agenda.
How do you find yield amid negative real rates and a potential rising rate environment?
Amid increased inflation expectations, negative real rates, a bear steepening of the yield curve, a potential rising rate environment, mixed economic data, and the uncertainty of complete post-COVID employment normalcy all depict a near-term contained inflation runoff. Therefore, short-term corporate bonds, non-agency RMBS, and floating-rate notes could prove to be shining stars amid an uncertain fixed income landscape. As explained in Fixed Income’s Year Ahead 2021: Short-Term Corporate Bonds & Legacy Non-Agency RMBS both short-term corporate bonds and legacy non-agency RMBS remain attractive for risk-adjusted returns. Additionally, floating-rate notes’ recent resurgence could be an additional hedge to inflation and an alternative avenue to capture yield. With yield hard to find and interest rates’ potential to rise off historic lows, floating-rate notes’ typical senior liens (reducing default rates) offering higher yields remain attractive during the present macro environment.
Currently, the leveraged loan or floating rate market shows signs of health amid increased issuance supporting inflationary pressures. Investors’ increased appetite for inflation protection has shifted the U.S. market back to selling floating-rate notes. January was one of the busiest months for floating-rate bond issuance in a year with approximately $10 billion issued (more than doubled from the 2020s $4.2B monthly average). As the U.S. government plans for a $1.9 trillion COVID relief package (amid a weak January jobs report), investor concerns about inflation are returning (after the floating rate notes outstanding have been falling since 2018 as interest rates ceased rate hikes). Therefore, there is a demand for floating-rate notes to hedge inflation risk and avoid negative total returns on the longer end of the yield curve (bear steepening). Therefore, the current mixed economic environment and a better sector mix than high-yield corporates may support the floating rate demand as an increasing rate environment becomes more likely. Thus, floating-rate notes exhibit strong fundamentals as projections depict a yield around 4% in 2021 amid an improving economy, rising interest rates, and rebounding corporate profits.
Though inflation expectations remain debated as the Fed has pledged to pin interest rates to the lower bound until inflation rises back to 2% (currently 1.4%), the increased M1 supply (QE and stimulus packages) have caused some inflationary tailwinds (current 2021 inflation expectations of approximately 2.24%). The inflation argument has some legs supported by robust M1 increases, a bear steepening environment, an increase in the gold to real rate spread, and a steep recovery of breakeven rate breaching pre-COVID levels (though slightly skewed to the upside). Adding fuel to the inflation fear fire, hard economic data remain supportive to near-term inflation increases as the Producer Price Index (PPI) posted its’ biggest gain since 2009 in January, rising to 1.3. This could signal an increase in Consumer Price Index (CPI) as PPI provides an advanced indicator of price changes throughout the economy (consistent with increased inflation expectations for the second half of 2021).
Though inflation remains in check (for now) amid low yields and a rising rate environment, premature inflation anticipation further complicates an already nuanced fixed income market. However, a few specific fixed income classes provide opportunities amid the economic haze. Fixed-income investors can find value in a short-term corporate bond, legacy non-agency RMBS, and bank loans/floating rate strategies.