Investment insights from Capital Group
We have seen an interesting paradox in the markets over the last couple of months: 10-year U.S. Treasury yields and breakeven rates on 10-year maturity TIPS (Treasury Inflation-Protected Securities) have moved lower even as inflation has moved meaningfully higher.
Headline inflation has surprised to the upside over the last two months, rising 0.8% month over month in April and 0.6% in May ― among the two biggest monthly increases since 2009. And April’s 0.9% month-over-month increase in the core Consumer Price Index (CPI), which strips out volatile food and energy components, was the highest in nearly 40 years.
Consumer price inflation surges
Despite these upside surprises, Treasury yields and TIPS breakevens have moved lower. Since mid-May, when the first set of strong CPI data was released, 10-year Treasury yields have dropped from 1.69% to 1.50% and 10-year inflation breakevens have declined by 24 basis points. (The TIPS breakeven rate is the difference between the yields of Treasuries and TIPS of the same maturity.)
Two expectations likely helped drive this move: first, that elevated inflation readings are likely to be transitory; and second, that the Fed would be more likely to change its policy stance if inflation started running too hot. We question both assumptions.
The Federal Reserve’s June 16 meeting brought inflation concerns to the forefront as it made what some market participants saw as a “hawkish pivot” to a more aggressive timeline for tighter monetary policy. Fed chair Jerome Powell acknowledged these concerns in the June meeting press conference, saying longer-term inflation expectations have risen to a range consistent with the Fed’s long-run goal of 2%.
Powell also asserted that while factors driving higher inflation readings are likely to be temporary, they could push inflation even higher and remain persistent for some time. Importantly, he mentioned several times during the press conference that the Federal Open Market Committee (FOMC) “wouldn’t hesitate” to use its monetary policy tools should inflation or inflation expectations move higher — meaning potentially a faster end to policy accommodation.
The median FOMC participant has now penciled in two rate hikes by the end of 2023, up from zero in March. In addition, seven out of 18 members project a move in 2022, up from four.
Fed projections of higher rates
The door is now open for the Fed to move toward tapering its asset purchase program, with an announcement possible as soon as the September FOMC meeting if inflation and employment data surprise to the upside.
Investors digested the message from the June meeting as a hawkish signal, resulting in a meaningful rise in short-term Treasury yields, a fall in longer-term yields, and a cheapening in the pricing of inflation expectations via TIPS.
Our view in the interest rates team is that, even accounting for this more aggressive scenario, rate hikes are still at least a year away. The Fed will likely fully implement its asset reduction program before lifting rates, following the playbook from the aftermath of the global financial crisis. Fed officials have made it clear that this is their preferred sequence for removing policy accommodation. Powell also made it a point to say that the policy discussions beginning within the FOMC were related to asset purchases, not rate hikes.
We think that the exodus from reflation trades and the pricing of more imminent rate hikes may be premature for a few reasons:
The Fed will need to adjust its asset purchases first before considering rate hikes, as Powell has stated many times in the past and reiterated on June 16. TIPS inflation expectations have more room to run in an environment where the Fed is likely to continue to add liquidity to the system for some time, as well as the potential for more upside surprises in the CPI.
When we look at the underlying components of CPI, we think the upside risk to inflation exceeds the downside of what is priced in. Given low starting points and monthly base effects, it won’t take much to see very high year-over-year core inflation rates in the next 12 months. Even in a benign scenario, where the monthly increase in CPI softens to the pre-pandemic trend of around 0.15% month over month, annual core inflation will likely stay above 3% until late spring 2022.
In the more likely scenario where inflation pressures abate more gradually in the coming months, it could translate into an annual core inflation rate as high as 5% into next year — readings we haven’t seen since the early 1990s.
Select goods categories such as used cars and trucks, furniture and electronics are likely to continue experiencing higher prices due to ongoing supply-demand mismatches. As a result, goods inflation may continue to feed into the core CPI.
We have also been surprised by the quick rebound in rent and owners’ equivalent rent. It has accelerated back to the pre-pandemic trend, and based on the rebounding labor market, there could be further increases. We could also see broader inflationary pressures in services as the economy reopens further this summer and fall. Finally, the effects of extraordinary monetary and fiscal policy are still working through the system and are likely to contribute to any upward inflationary impulse.
Owners’ equivalent rent marches higher
We continue to invest in TIPS where appropriate and prefer investing in the front end of the yield curve versus the intermediate- and long-term maturities. We think short-term Treasuries with maturities of two years or less are attractive on the view that any Fed hike is unlikely before the end of 2022. On the other hand, intermediate five-year to 10-year Treasury yields should rise on inflation concerns.
Given that the slope of the five-year vs. 30-year Treasury yield curve flattened by 20 basis points in the week following the June Fed meeting, and the long bond yield has fallen by about 10 basis points, we also favor an underweight position in 30-year Treasuries. We have an overweight allocation to TIPS and especially favor five-year maturities, given our view that inflation could continue to surprise to the upside.
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