Higher U.S. inflation may be lurking just over the horizon. Wages, rents, health care, and energy costs rose while the Federal Reserve (the Fed) remained too boxed in by global economic conditions to aggressively raise interest rates. If the Fed further delays interest-rate normalization, inflation could rise. Meanwhile, the cost of inflation-indexed securities remained relatively low, providing investment and risk-management opportunities for the portfolios we actively manage.
Read MacEwen’s full Q3 2016 CIO Insight:
Delayed Interest-Rate Normalization Builds Case for Inflation Protection
Our CIO Insights Introduction piece this quarter (The Economy Is Truly Global) discusses how interest-rate normalization in the U.S. has been delayed. Our view is that the timetable for this much-anticipated interest rate change has been altered in large part by soft global economic factors beyond the Fed’s control. Central banks outside the U.S. have mostly been battling deflation for the past two years, not inflation. Global deflationary factors tied to China’s slower growth are tying the Fed’s hands.
U.S. Core Inflation Chugging Steadily Higher
In the U.S., inflationary forces are somewhat stronger. Domestic factors that could feed higher inflation include improved labor and housing markets, solid consumer spending, higher wages, and rising costs for rents, health care, energy, and secondary education. Furthermore, after a slow start to the year, U.S. economic growth is expected to accelerate in the second quarter.
Global factors, such as China’s growth, have been inhibiting so-called “headline” U.S. inflation, as published monthly by the Bureau of Labor Statistics in its Consumer Price Index (CPI). Meanwhile, “core CPI” (headline CPI minus volatile food and energy prices) has been chugging steadily higher for the past year, and has passed the 2% level. We think it could approach and broach 3% later this year, boosted by the U.S. inflation factors highlighted in the prior paragraph. Headline inflation remains tame, but could follow core higher.
We Believe Inflation Measures Will Eventually Converge
However, as we’re writing this in mid-June, some key market indicators for inflation haven’t flashed strong warning signs yet. For example, the 10-year U.S. Treasury yield remained below 2%, well below its historical average. So did the difference between the 10-year U.S. Treasury yield and the yield for 10-year U.S. Treasury inflation-protected securities (TIPS). This so-called “10-year breakeven inflation rate” is viewed as a bond market projection of the U.S. inflation rate for the next 10 years.
Our Global Macro Strategy Team’s base-case inflation scenario envisions that the divergence between headline and core U.S. inflation may be ending but will remain subject to the future direction of commodity prices. The team believes that headline inflation will eventually converge with core inflation, and that a stabilization in commodity prices coupled with continued U.S. economic growth ultimately will create higher inflation than is currently priced into the bond market.
TIPS Are Relatively Inexpensive
The bond market’s pricing of inflation risk (as of this writing) is good news for investors seeking to manage their future inflation risk. Breakeven inflation rates below 2% indicate that TIPS are relatively cheap compared with regular U.S. Treasury securities. We believe investors should consider inflation-protection securities and strategies as part of an overall risk-management strategy for their portfolios, especially now, while the cost of adding those strategies/positions is relatively inexpensive.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of G. David MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.
For educational use only. This information is not intended to serve as investment advice.