Fixed Income: What about inflation?

Wealthbar Ad

WT_Blog_722x140_FixedIncome

kevin-temp2By Kevin Flanagan, Senior Fixed Income Strategist, WisdomTree

Special to the Financial Independence Hub

The last few months have certainly given the money and bond markets a lot of divergent news headlines to digest. Not surprisingly, the focus has been on negative rates abroad, geopolitical events and, a bit more recently, some better-than-expected employment news juxtaposed with a softer-than-expected GDP report. That begs the question: What about inflation? Isn’t that a key ingredient in the bond market mix?

Without a doubt, U.S. inflation data has taken a backseat for fixed income investors, and for good reason; there just haven’t been any fresh developments lately. Certainly, the conversation has shifted from a year ago, when deflation concerns were permeating market psychology. But the latest figures don’t elicit concerns that price pressures will be rearing their ugly head anytime soon, or at least that’s what the collective thinking is in the fixed income markets.

Breakeven inflation ratesvrGP Breakeven-Inflation-Rate

So, what does the inflation backdrop look like? According to the widely followed Consumer Price Index (CPI), the year-over-year inflation rate came in at +1.0% in June (Note 1)—very little changed from the readings posted over the last four months, but definitely higher than the +0.1% for the same month in 2015. The core gauge, which excludes food and energy, rose at a +2.3% annual clip and has been residing in a range last seen in 2012. There continues to be a large dichotomy between core goods (-0.6%) and core services (+3.2%) .(Note 2)

As part of its dual mandate, the Federal Reserve (Fed) addresses inflation trends and its outlook in its FOMC meeting policy statements as well as focusing on expectations. In fact, inflation expectations play a pivotal role in the voting members’ deliberative process, because once a certain sentiment becomes embedded, it can become difficult to reverse.

A primary way to gauge these expectations lies in what is known as “breakeven inflation rate.” This measure is the difference between the yield on a nominal bond (such as the U.S.Treasury 10-Year note) and an inflation-linked or real yield bond with the same maturity (such as the 10-Year U.S. Treasury Inflation-Protected Securities, or TIPS). This difference, or spread, is viewed as representing the expected rate of inflation.

Utilizing our graph as a guide, the breakeven rate between the UST 10-Year yield (1.55%) and the UST 10-Year TIPS (0.05%) is 1.50%, not too far removed from the five-year low of 1.20% posted during this year’s peak “risk-off period,” and considerably below the high point of 2.64% registered in September 2012. In other words, expectations are for an inflation rate of roughly 1.5%, another factor that not only provides the Fed with no urgency to raise rates but also gives it time to continue to “closely monitor … global economic and financial developments.” (Note 3)

Conclusion

Looking ahead, it seems more than likely that increasing price pressures are not building on the horizon. The effects of the prior strength in the U.S. dollar tend to lag and could continue to pass through and act as a drag on inflation. General economic slowing abroad, especially in China, may also weigh on prices in the goods sector. The Fed’s preferred gauge, the core PCE price index, has been running at a +1.6% (Note 4) annual rate the prior four months and does not look poised to hit the policy makers’ +2% threshold in 2016.

1  Source: Bureau of Labor Statistics, as of 7/15/2016.
2  Source: Bureau of Labor Statistics, as of 7/15/2016.
3  Source: Federal Reserve as of 7/27/2016.
4  Bureau of Economic Analysis as of 8/2/2016.

Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

Commissions, trailing commissions, management fees and expenses all may be associated with investing in WisdomTree ETFs. Please read the relevant prospectus before investing. WisdomTree ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

Past performance is not indicative of future results. This material contains the opinions of the author, which are subject to change, and should not to be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. There is no guarantee that any strategies discussed will work under all market conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This material should not be relied upon as research or investment advice regarding any security in particular. The user of this information assumes the entire risk of any use made of the information provided herein. Neither WisdomTree nor its affiliates provide tax or legal advice. Investors seeking tax or legal advice should consult their tax or legal advisor. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.

The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or component of any financial instruments or products or indexes. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each entity involved in compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties. With respect to this information, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including loss profits) or any other damages (www.msci.com)

“WisdomTree” is a marketing name used by WisdomTree Investments, Inc. and its affiliates globally. WisdomTree Asset Management Canada, Inc., a wholly-owned subsidiary of WisdomTree Investments, Inc., is the manager and trustee of the WisdomTree ETFs listed for trading on the Toronto Stock Exchange.

 

Leave a Reply