Inflation: The Long, Long Wait

Mid Week Bond Update

Inflation: The Long, Long Wait

Inflation and growth have failed to tick higher, despite the efforts of central banks. What are the implications going forward?


The world’s major central banks have targeted an inflation rate of 2% for nearly a decade, for the most part keeping their policy rates at record lows to ignite global growth. Yet both inflation and growth have failed to tick higher. What are the implications going forward?

G10 GDP Weighted Core Inflation

Chart courtesy of Western Asset. Sources: Western Asset, J.P. Morgan. As of 30 Sep, 2019. 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.
 

The loosening of the links between growth, employment and inflation has been a persistent challenge for the world's major central banks, making it increasingly difficult for them to boost growth with the monetary tools at their disposal. One result has been growing calls for developed-market governments to follow the U.S. example in deploying fiscal stimulus. Another has been the growing bias among central bankers to continue to suppress rates until after inflation and growth begin to pick up. 

As Western Asset CIO Ken Leech points out, the result is that it’s very unlikely central banks will tighten policy for a long time. Their “reaction function” has become extremely asymmetric – quick to ease on weaker economic conditions, but very slow to tighten. The result has been a strong year for fixed-income returns, especially in spread sectors. Western Asset observes that if the dynamics of growth and inflation persist, spread sectors could continue to strengthen, if not to the same dramatic degree as in 2019 so far.
 

On the rise: U.S. business-sector debt as a percent of GDP

In its November 2019 Financial Stability Report, the Federal Reserve observed that vulnerabilities arising from total private-sector credit are at “moderate levels”. Even so, business-sector debt relative to GDP is historically high amid relatively weak credit standards.  

Household debt, at about 80% of GDP, appears quite prudent – down from about 110% of GDP at the peak of the 2007-9 recession. But non-financial businesses, in contrast, have already seen their debt rebound to the recession peak of about 74% of GDP. At the same time, the Fed observes that “credit standards for some business loans remain weak, and balance sheet leverage of businesses is near its highest level over the past two decades.”

However, the Fed also notes that historically low interest rates have contributed to keeping the ratio of corporate earnings to interest expenses high and near the historical median for riskier firms. In other words, while the current interest rate environment remains in place, the burden appears to be manageable on the basis of corporate cash flow.  
 

On the slide: U.S. Treasury Yields 

Down by just over 11 basis points on the day, 10-year Treasury yields reached as low as 1.516% on December 31 before rising slightly to 1.533%. That’s about 2.7 standard deviations away from the 90-day average – a significant downdraft.  

The cause appears to be increased pessimism about an early resolution of global trade conflicts between the U.S. and its trading partners, including China.  The pessimism may have been brought about by comments made by President Trump while attending the NATO summit in London on Tuesday that he might prefer to make a deal after the November 2020 election rather than before. That position contrasts with White House economic advisor Larry Kudlow’s statement more than two weeks ago that talks were “coming down to the short strokes.”  As things currently stand, the Trump administration has threatened to impose tariffs on more Chinese imports starting on December 15, including items such as smartphones, toys and children’s clothing.

 

Note: The year for all dates is 2019 unless otherwise indicated


1 Source: Bloomberg, December 3, 2019, 10:58 AM ET


Definitions:

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

The Group of Ten (G-10 or G10) refers to the group of countries that agreed to participate in the General Arrangements to Borrow (GAB), an agreement to provide the International Monetary Fund (IMF) with additional funds to increase its lending ability.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

Core inflation excludes the prices of food and energy, which are volatile on a monthly basis, from the basket of goods used to determine overall inflation.

Spread sectors refers to sectors of the bond market, such as taxable bonds that are not Treasury securities, and includes securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

One basis point is one one-hundredth (1/100, or 0.01) of one percentage point.

The North Atlantic Treaty Organization (NATO) is an international organization composed of the US, Canada, Britain, and a number of European countries: established by the North Atlantic Treaty (1949) for purposes of collective security.

 

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