Reflections on Reflation – Why This Time Feels Different for TIPS

Reflections on Reflation - Why This Time Feels Different for TIPS


Q2 2017 CIO Insights – Fixed Income

Global financial markets experienced several shocks last year, not the least of which was the election of President Trump and the resulting reflation expectation-fueled risk market rallies. We discuss the “Trump Bump” and its potential aftermath in our CIO Insights Introduction piece this quarter—“Risk-Market Rallies Meet Policy Implementation Realities.”

Inflation-protection strategies and securities, including Treasury inflation-protected securities (TIPS), have been the subject of prior Insights. But there’s a difference this time, and it’s not just President Trump and his policies. We discuss what we’re seeing and how investors can position their portfolios.

Trump Could Bump More than Growth

Underlying the “Trump Bump” were key potentially inflationary/reflationary tenets of “Trumponomics”—the Trump administration’s package of policy proposals seeking to stimulate stagnant U.S. economic growth. Trumponomics proposes to add significant fiscal stimulus at a time when monetary policy remains stimulative and the U.S. economy appears to be significantly reducing some of its slack, particularly in the labor market. It’s fair to ask whether more fiscal stimulus would improve economic growth, or simply drive up prices.

“This illustrates an important point—inflation is trending higher, but it isn’t high yet.”

A rebound in inflation expectations actually started last summer, after China- and oil-related deflation fears in the first half of last year. A key measure of the bond market’s inflation expectations is the 10-year breakeven rate, the yield difference between 10-year U.S. Treasury notes and 10-year TIPS. This rate rose from 1.34 percent in July 2016 to 2.08 percent in January 2017, a significant six-month move, but still below the rate’s historical average, which is closer to 2.30 percent. This illustrates an important point—inflation is trending higher, but it isn’t high yet. Our concern isn’t so much with present inflation levels. It’s with the extended upward trend in some measures, and the potential for even higher inflation in the coming year or two.

Recent Trends Suggest Higher Prices

We’ve warned about higher inflation before. What’s different this time? An obvious answer is the policy package described above. But that’s not the only new factor. In broad terms, the global economy appears to be changing, and these six recent trends suggest higher prices:

1. Synchronized global economic growth. The U.S., Europe, Japan, and China are improving at the same time.

2. No more deflation fears. Post-2008, deflation was a periodic concern. No longer.

3. Coordinated oil supply curtailment. There may be more risk of oil prices moving higher than lower after major oil-producing countries agreed to reduce production.

4. Goods costs starting to increase. In recent years, increasing service costs, such as medical expenses, have boosted inflation more than goods. Now goods costs are ticking higher too.

5. U.S. wage pressures. Declining slack in the U.S. labor market has started to drive up wages.

6. U.S. inflation appears to be outpacing U.S economic growth. Annual headline inflation is over 2 percent, while economic growth is still struggling to exceed that level.

Total Return Opportunity for TIPS

For these reasons, and others, we believe there’s more inflation risk in our future than what’s priced into the bond market—enough to invest a small portion of portfolios in TIPS and/or other inflation-protected securities. If breakeven rates are near 2 percent at the time of investment, there’s an opportunity for TIPS to outperform high-quality nominal bonds if inflation expectations move toward their historic 2.30 percent average or higher.

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.