With inflation insurance back in vogue, should bond investors be worried?


Some investors are tentatively bracing for inflation to make a comeback.

Prices of Treasury-inflation protected securities have steadily climbed throughout 2019, amid talk that the Federal Reserve could refrain from immediately tightening its leash when inflation overshoots the central bank’s 2% target. Though the year-to-date decline in Treasury yields, including a brief inversion of the 3-month/10-year curve, signals that bond investors have few fears of pent-up price pressures, the buoyant performance of instruments that function as insurance against a pickup in inflation shows many aren’t taking any chances.

“If [Fed] policy is set in order to achieve cyclical overshoot to the [inflation] target, breakevens should move higher,” analysts at Deutsche Bank said.

Analysts have keyed into recent discussions of price-level targeting among senior members of the Federal Reserve. Under that policy, the Fed would aim for inflation to average 2% instead of treating it as a ceiling. In other words, inflation could be allowed to temporarily overshoot the 2% target to make up for times when it was stuck below that level.

The iShares TIPs Bond ETF

TIP, -0.11%

is trading at $112.64 a share, up from a November low of $108.28. Since the start of the year, the exchange-traded fund tracking the performance of Treasury-inflation protected securities is up nearly 3% this year, FactSet data show. That’s above the 2.3% a plain-vanilla Treasury bond exchange-traded fund

GOVT, -0.26%

has returned to investors in 2019.

Treasury-inflation protected securities benefit from higher consumer prices as the bond’s principal float along with the ups and downs of inflation, though the individual fixed-interest payments remain fixed.

Higher inflation could spell trouble for those who bought long-dated bonds on the belief that the U.S. central bank would stay on pause as long as price pressures appear muted.

Since the start of the year, the S&P 500

SPX, +0.55%

has advanced more than 15%, while the 10-year Treasury yield

TMUBMUSD10Y, +1.90%

has retreated nearly 20 basis points to 2.55%, FactSet data show. Bond prices rise when yields fall.

See: It’s hard to believe, but the U.S. has gone through a quarter-century of low inflation

But inflation expectations have risen in the past few sessions. The 5-year, 5-year forward break-even rate, which tracks the average expected inflation rate over the coming five-year period beginning five years from now, gaining around 11 basis points to 2.05% from a recent low of 1.94% at March 27.

To be sure, that’s a relatively modest increase given that the bond market’s short-term inflation expectations have lingered around 2% for most of 2019.

And though consumer prices and wholesale prices showed robust increases in March this week, the prospect of a flare-up in price pressures seems distant after their more stable core gauges, which strips out for volatile energy and food prices, showed muted gains. Analysts said the recent round of inflation data was driven by higher oil prices more so than fading global economic headwinds.

Wednesday’s CPI data “will not change how the Fed is thinking right now, that is, staying on hold for the rest of the year. The TIPs market is still painting a depressed inflation picture,” Tim Magnusson, senior portfolio manager at Garda Capital Partners, told MarketWatch.

Market participants insist a tight labor market would eventually produce the wage gains and inflation pressures needed to keep the Federal Reserve vigilant on monetary policy. But even as unemployment rates have plumbed multidecade lows, higher inflation readings have yet to materialize, anchoring demand for bonds.

Around $106 billion of cash has poured into fixed-income assets this year, based on EPFR data.

Still, big money managers like Pimco and BlackRock say Treasury-inflation protected securities will perform well this year. And Allianz Global Investors say they’re also betting on a modest rebound in U.S. inflation through derivative contracts.

Talk of a tolerant Fed stands in contrast to criticism of the central bank, including a litany of complaints from President Donald Trump, over a steady stream of rate increases that saw policy makers lift the fed-funds rate four times in 2018. The Fed made an abrupt about face in January, shelving plans for further increases as it took a wait-and-see approach to policy. In March, policy makers signaled rates were unlikely to rise in 2019, while market participants have bet on a potential rate cut.

Bullish buyers of TIPs have cited recent discussions by the Federal Reserve to make their inflation target more credible amid fears the central bank’s efforts to rein in inflation had proven too successful in containing inflation expectations. The concern is the central bank might be willing to allow the labor market to heat up further before it responds.

“The Fed is looking to run the jobs market superhot going-forward through said ‘policy asymmetry’…in order to reset inflation expectations,” wrote Charles McElligott, a cross-asset strategist at Nomura Securities.

Fed officials are conducting a review of the central bank’s policy framework. Fed Vice Chairman Richard Clarida has said price-level targeting could be an option. European Central Bank President Mario Draghi also hinted that the central bank’s near-2% inflation target was not a ceiling during a news conference following its monetary policy meeting this week. The urgency for a shift in the Fed’s inflation policy comes as central bankers puzzle over the persistence of subdued prices.

“Even though there was nothing officially announced, price-level targeting seems to be part of an ongoing discussion. That’s sort of the big unknown,” said Liz Ann Sonders, chief investment strategist for Charles Schwab, in an interview with MarketWatch.

Yet with the Fed’s preferred inflation gauge, personal-consumption expenditures, retreating below 2% in the past few months, the bond bulls may feel tempted to kick up their feet for now.

Read: Muted inflation is taking Fed out of the picture for bond buyers

Providing critical information for the U.S. trading day. Subscribe to MarketWatch’s free Need to Know newsletter. Sign up here.

Source : MTV