What Inflation?

For some time now we’ve been hearing worries about the inability of most bonds to keep pace with inflation. Because bonds are “fixed” income investments, the ability to exceed inflation is a major concern, especially in a low interest rate environment. The truth is, despite what your grocery bill may look like, inflation is actually quite weak right now. The core consumer price index (CPI) which excludes food and energy, is currently running at 1.8% year-over-year as of October, less than the Fed’s 2% inflation target.

Well what about inflation expectations, or future inflation, you ask?

The 5-year break-even inflation rate, calculated by subtracting the yield on a Treasury Inflation-Protected Security from that of a nominal US Treasury note is currently 1.48%, the lowest it’s been since October 2011. This implies investors expect inflation to average 1.48% annually over the next five years, in-spite of years of a near-zero Fed Funds rate and massive quantitative easing by the Federal Reserve.

Recent inflation readings, despite an uptick in US GDP (normally inflationary) since the starkly negative growth from Q1, have quieted both inflation hawks on the Federal Open Market Committee and economic pundits alike. Data from the Chicago Mercantile Exchange’s FedWatch indicates the market expects the Fed, whose dual mandate is full employment and stability of prices, to raise rates towards the end of 2015, as opposed to the first or second quarter as previously believed.

What factors are contributing to low inflation and potential continuation of accommodative monetary policy?

Among others, weakening worldwide economic growth is likely the largest factor. Weak growth and the expectation of greater quantitative easing by the European Central Bank (ECB), has pushed Eurozone sovereign debt to record lows (the German 10-yr yields 0.74%!). Improving US economic conditions and a global search for yield has made the US an attractive place for foreign investors, whether in Treasuries or riskier domestic investments. The stronger dollar also makes foreign goods, and as a result domestic goods, cheaper for American consumers. Although energy is not included in core inflation, oil, and as a result gasoline, is also cheaper. Another factor is tepid wage growth, even in the face of solid employment gains in the US, which is seen as both a consequence and cause of weakening inflation.

What does this all mean for bonds?

As yields around the world stand at or near record lows, with the potential to go lower if the ECB begins buying sovereign debt, it’s hard to expect domestic interest will rise the way most investors and economists expected heading into 2014. This sounds like more frustrating news for bond investors, but there is a silver lining! The purchasing power of a bond’s coupon is enhanced as inflation falls, which is definitely something to feel good about. We continue to seek bonds with justifiably higher yields than peer bonds of similar rating and maturity using a fundamental approach.