Is Inflation Protection Passe? Not Quite by Vinod Chathlani, AllianceBernstein
Investors have been waiting all year for the Federal Reserve to acknowledge stronger US growth by raising rates. Then, a funny thing happened: market inflation expectations plunged. Does this mean deflation looms? We don’t think so.
It’s not a surprise that investors don’t see much inflation over the next three or six months. A steady decline in oil and other commodity prices since mid-2014, a strengthening US dollar and a sharp slowdown in China have all kept price pressures at bay.
Here’s what is curious: markets, unlike the Fed, don’t think the current low inflation rate is temporary. We can see this by looking at the sharp decline in the five-year forward breakeven rate— what the market thinks inflation will be over a five-year period that starts five years from now. The breakeven rate is easy to calculate: just subtract the yield on Treasury Inflation Protected Securities (TIPS) from the yield on Treasury bonds.
In September, the inflation breakeven rate plummeted to levels not seen since the global financial crisis. Let’s put it another way: the market is saying, don’t expect the Fed to achieve its inflation target until 2025. If that’s right, investors might be tempted to simply avoid inflation-sensitive assets.
We think that would be a mistake.
More than Meets the Eye
Why? Market-based indicators may be understating inflation. Market inflation expectations fell to between 1.5% and 2% during the third quarter. But consumer expectations of inflation are higher. Based on monthly and quarterly surveys, consumers expect inflation of 2.5% to 3% in 5 to 10 years—a number that’s been pretty stable (Display).
What’s behind this discrepancy?
One reason for it has to do with how bonds’ nominal yields work. They include a yield premium for inflation risk. That’s the premium investors demand for the risk that future inflation may end up being higher than the market expects.
Because inflation has stayed low (from low energy prices and a strong US dollar), investors demand less of an inflation risk premium than usual. This pushes nominal bond yields closer to the real yields on TIPS, narrowing the gap. The smaller difference between the two yields distorts the market’s true inflation expectations for the next five to 10 years, making them appear lower than they really are.
The market’s reaction to recent turmoil also plays a part in the narrower yield gap between Treasuries and TIPS. Investors started worrying that slower growth in China would hurt US corporate earnings, leading to slower wage growth, weaker consumer spending and low inflation.
These contagion fears spurred investors to seek safety in nominal Treasuries, which further compressed nominal yields relative to real yields. This helps explain why the market’s medium-term inflation expectations fell in September to levels last seen during the global financial crisis in 2008.
The Market Overreacts
A shrinking inflation risk premium and flight to safety combined to lead one of the biggest quarterly declines in the market’s inflation expectations in the last decade. We don’t think the economic fundamentals justify such a weak inflation outlook.
For one thing, the US economy may still be below pre-financial crisis peaks, but it’s clearly on the mend. Employment conditions, companies’ capacity utilization and credit growth are all on the upswing. Secondly, as energy prices near a bottom and the stronger dollar trend loses momentum, inflation risk premiums should begin to rise again, back to more normal levels.
Finally, we think markets are overestimating the damage that slower Chinese growth and global trade weakness can inflict on the US economy. US exports to China and other emerging markets are low compared to other developing countries. And consumer-oriented businesses may benefit from lower energy prices.
Upside for Inflation Sensitive Assets
What does all this mean for investors?
Put simply: inflation-sensitive assets are attractively valued —in some cases, almost as cheap as during the global financial crisis. We don’t expect inflation to take off in the near term, but we certainly think the worst might be over for inflation-sensitive assets. At this point, they offer attractive risk-reward.
If the Fed is right and low inflation is temporary, longer maturity TIPS and other inflation-sensitive assets could have a lot of room to rally.