The Bond Markets Interpretation of Inflation

<b>Eric C. Jussaume</b><br> Senior Vice President<br>Senior Portfolio Manager<br>& Director of Fixed Income<br><br><b>Lindsey K. Donovan</b> Assistant Vice President, Investment Analyst & Trader

Eric C. Jussaume
Senior Vice President
Senior Portfolio Manager
& Director of Fixed Income

Lindsey K. Donovan Assistant Vice President, Investment Analyst & Trader

September 21, 2020

Investing & Economy


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Over the past twelve months there have been close to 600 global stimulus measures to help spur economic growth. There is concern that all these measures could lead to higher inflation. At their September meeting, the Federal Reserve left interest rates near zero and forecasted holding them there through at least 2023 to help the US economy recover from the coronavirus pandemic and achieve maximum employment. This is a forecast and not a promise that rates will stay low. Additionally, the Fed is still targeting 2% inflation and may raise rates if inflation is on track to moderately exceed 2% for some time. There are several measures used to indicate the presence of inflation in the economy.

One indicator of inflation that is frequently cited is the relative price change of the value of goods and services. This metric is measured through the Consumer Price Index (CPI). CPI consists of a bundle of goods and services, including food, energy, rent, and transportation. In August, CPI increased by 0.4%, totaling an increase of 1.3% over the prior twelve months. However, while short-term relative price change may be painful, it does not always reflect long-term price change. Inflation occurs when the entire basket of goods and services increases, therefore short-term increases are not always indicative of long-term inflation. The high levels of unemployment that the economy has experienced since the beginning of the pandemic, reported at 8.4% for August, means that increases to services like shelter (one-third of CPI) are likely a component of inflationary pressure that will not come to bear for some time.

In monetary policy, the main measures used to look at inflation are the velocity of money (Chart 1) and the M2 money supply (Chart 2). The velocity of money is a measurement of the rate at which currency is exchanged in the economy and tracks the number of times that money moves from one entity to another. It is calculated as the ratio of the nominal GDP of a country divided by the money supply (V = PQ/M). When the velocity of money decreases, we can infer that there are fewer transactions happening in an economy, as less money is changing hands. When transactions decline, the probability of the economy contracting is higher. The velocity of the M2 money supply from the Federal Reserve was 1.10 in the first quarter of 2020, the lowest ever recorded. M2 is a frequently used tracking mechanism of the money supply, it includes currency in circulation (M1) as well as savings accounts, money market accounts, and certificates of deposit. The recent increase of M2 to over $18 trillion is due to recent changes to monetary and fiscal policy in order to fight the pandemic, while the concurrent decline of the velocity of M2 shows that consumers and businesses are spending less cash and saving more due to the fears from the pandemic. If velocity were increasing as M2 increased, we might have seen inflationary pressure, as the amount of money was increasing while output remained flat; however, we also saw the personal savings rate increase, telling us that the stimulus money was not going into circulation but instead staying in savings. 
 

Chart 1



Chart 2




We think it is important to view what the bond market is pricing in for inflation. The US Treasury has been issuing Treasury Inflation Protection Securities (TIPS) for many years. TIPS differ from nominal US Treasuries in that their principal is adjusted for changes in CPI. If CPI increases, the principal value of the bond increases. Conversely, if CPI declines, the principal value will be adjusted downward. During periods of declining inflation as measured by CPI, it is possible to have a lower principal value upon maturity than your original investment, if originally purchased at a premium in the secondary market. Also, like all bonds, TIPS bond yields change along with changes in interest rates. As we have written over the past several months, interest rates are at historical lows and the yields on all TIPS maturities are now negative as the market adjusts TIPS yields in relation to the extremely low traditional Treasury yields.  The breakeven inflation rate is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.  For example, at the 10-year point on the curve, the market has priced in an expectation of forward inflation to average 1.62% over the next 10 years. This rate is below the Fed 2% inflation target. Chart 3 shows that this difference has increased since March.
 

Chart 3





The inflation breakeven rate is not necessarily an independent forecast but is rather an implied snapshot of today's inflation expectations.  The inflation breakeven rate is a more effective measure of the relative value of TIPS versus nominal Treasuries than predicting future inflation.  However, this relationship is still a very helpful barometer of market inflation expectations, and it has perked up recently.

With the massive amounts of monetary stimulus over the past years and record low levels of interest rates dictated by central banks, it is difficult to determine what normal interest rates level should be, and ultimately the breakeven inflation rate. We continue to rigorously debate inflation within our investment group as inflation can erode the purchasing power of the income earned from an investment and could require repositioning bond portfolios. Although the breakeven rate has increased in recent months, we are not yet at a point where a sustained breakout is expected in the near term.

 

Resources:


Strategas Article, Checking in on Inflation vs Deflation, 9/10/2020

https://seekingalpha.com/article/4153595-inflation-breakeven-rate-what-really-tells-you-tips
 
https://www.stlouisfed.org/on-the-economy/2014/september/what-does-money-velocity-tell-us-about-low-inflation-in-the-us