Inflation is famously difficult to measure – and could very well be lower than some may assume – a potential benefit for investors with longer-than-benchmark duration.
Inflation expectations have a direct impact on fixed income valuations, both in the short and long run. But this all-important measure is famously difficult to measure – and could very well be lower than some may assume. That, in turn, could mean a benefit for investors with longer-than-benchmark duration.
Four Measures of U.S. Inflation, 2015 – 2018
Source: Bloomberg, June 18, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
U.S. core Consumer Price Index (CPI) inflation, annualized and seasonally-adjusted by the Bureau of Labor Statistics, rose above the Fed’s well-known 2% inflation rate in March 2018, and came in at an annualized 2.2% rate for May. Core CPI has given the FOMC some statistical backup for its stated inclination to hike rates twice in the remainder of 2018. However, there’s still the potential for distortion introduced by corrections for seasonal factors and the effect of “roll-off” of previous years’ monthly figures.
But CPI isn’t the only measure. Two of the Fed’s favored indicators don’t quite line up with it, or each other. The PCE Deflator, at 1.80%, is still below the FOMC’s 2% guideline. The market-based 5-year breakeven inflation rate shows 2.14% -- although some read this figure as reflecting inflation expectations for five years from now.
A lower inflation rate, of course, suggests current levels of yield, especially at the longer end of the curve, represent better value than many assume. Which, in turn, could suggest that holding more net duration could be advantageous, even if counter to consensus.
On the Rise: Trade-related uncertainty
Current trade conflicts centered around U.S. and China have been felt more deeply in the equity and commodity markets than in fixed income. The uncertainty in stocks has been company-specific as the dollar-value of the threats has risen by a factor of four or more over the past few days. For agricultural commodities, where futures contracts are used as hedging tools by growers planning next season’s crops, the short-term impact has been severe. November soybean futures traded at $911.5 per contract, down 13.5% from their highs on April 12.
The rapidly-ramping dispute may have been a contributing factor for the U.S. 10-year Treasury staying solidly below the closely-watched 3.0% level over the past week even after an intra-day downdraft apparently driven by the news cycle, the 10-year traded at 2.889%, well below its 3.007% spike on June 13th.
On the Slide: Theresa May’s Political Power
Brexit negotiations have reached back into UK politics; the issue of parliamentary approval of the not-yet-settled terms of an agreement now threaten the viability of Prime Minister May’s government. Not only might a vote in Commons result in her ouster, but the result could replace the Tories with a Remain-friendly Labour majority – making negotiations between the EU and the UK even more complex than they are already. This latest bout has shown up in the currency markets; the British pound is trading at $1.3186, down from its intra-day high of $1.3441 on June 14, four days before; UK gilts are trading at a yield of 1.29%, down from 1.39% on June 14th.
All data Source: Bloomberg, June 20 2018 10:00 AM EDT unless otherwise specified.