U.S. Inflation: Managing Expectations

Mid Week Bond Update

U.S. Inflation: Managing Expectations

Low expectations are making the Fed's battle to boost inflation harder.


Even in the best of times, the Federal Reserve's mandate to control inflation is difficult to achieve. Managing expectations for inflation along the way may be even harder, since expectations about the future change slowly yet strongly influence behavior in the present.

Consider the Fed's current dilemma. If manufacturers expect inflation to be tame over the next year or two, they will presumably be reluctant to raise prices for fear of losing market share and future profits. In other words, low expectations could make any attempt to stoke inflation via monetary policy harder.
 

Inflation Expectations: Two Views vs. the Market

Chart courtesy of Western Asset. Sources: Bureau of Labor Statistics, Haver Analytics, New York Federal Reserve, as of 12/31/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Three common measures of expectations suggest that the battle is far from won. The University of Michigan's consumer survey, as well as the New York Fed's inflation expectation forecast, are headed down rather than up. A key segment of the bond market suggests the same, with 5-year breakeven inflation spending most of 2019 below the Fed's 2% target inflation rate, showing scant signs of breaking through that level in 2020 so far. 

The inherent challenge of raising these expectations is one key reason that Western Asset's John Bellows expects the Fed to refrain from hiking its target interest rate in 2020 -- and perhaps cutting it further should conditions warrant. Discover this and other insights in The Fed: Outlook for 2020 .
 

On the rise: Spain's Record Issuance

Spain's sovereign bond sale on January 14th received orders for over €53 billion ($59 billion) for its €10 billion offering of 10-year bonds, beating its own record from January 2019 and making its order book the largest this year to date. After the sale, Spanish 10-year bonds held steady at a yield of 0.48%, a spread of about 64 bps above the equivalent German 10-year Bund, which traded at a negative -0.171% as of the close of trading that day.1

The success of the sale is a testament to the strong demand for positive-yielding euro-denominated debt despite the exposure to event risk during its relatively long 10-year life. The only 10-years with notably higher yields are Greece (1.374%) and Italy (1.3941%), each with its own economic and political challenges. Buyers of Spain's 10-year bonds appear to believe that the continuing turmoil over Catalan independence is not as urgent as the issues facing Greece and Italy. 
 

On the slide: Buenos Aires Creditworthiness

The province of Buenos Aires, Argentina's largest, notified holders of its notes with a payment due on January 26, 2020, that the province has "limited financial resources" and needs to delay the $250 million payment of principal on that date. Owners of at least 75% of the bonds need to agree to the delay in order to push the payment date to May 1. The proposed delay includes no additional payment to compensate for the delay.

The bond's rules say that an event of default will have occurred if a principal payment is at least 10 days late. If that happens without any change to the terms, holders of at least 25% of the debt can move to demand immediate repayment of the entire bond issue. The province set a Jan. 22 deadline for holders to agree to the delayed payment, and the country's economy minister said that there will be no bailout to help make the deadline. 

The International Monetary Fund (IMF) has a $56 billion commitment to Argentina's overall solvency and is expected to reveal the details of its plan on March 31. That may be one reason the bonds haven't been treated worse by the market; they fluctuated between 70 cents and 58 cents on the dollar on January 14, 2020.

 

Note: The year for all dates is 2020 unless otherwise indicated


1 Source: Bloomberg, January 14, 2020, 3:00 PM ET.


Definitions: 

A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).

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.

The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters. The index is normalized to have a value of 100 in December 1964. Each month at least 500 telephone interviews are conducted of a continental United States sample (Alaska and Hawaii are excluded). Fifty core questions are asked.

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.

U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

The 5-year, 5-year forward breakeven inflation rate is a measure of expected inflation derived from "nominal" Treasury securities and their "real" counterparts-inflation-protected TIPS securities.

An implied breakeven rate is a measure derived from comparing returns of two classes of securities whose value depends on the same factor, such as inflation or default rates. 

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

For details on the New York Federal Reserve 3-Year Inflation Estimate methodology and data, see Refet S. Gürkaynak, Brian Sack, and Jonathan H. Wright (2008), "The TIPS Yield Curve and Inflation Compensation," Finance and Economics Discussion Series 2008-05 (Washington: Board of Governors of the Federal Reserve System, November 12, 2007), also published as Refet S. Gürkaynak, Brian Sack, and Jonathan H. Wright (2010), American Economic Journal: Macroeconomics, vol 2, pp70-92. 

A spread is the difference in yield between two different types of fixed income securities with similar maturities. 

"Bunds" refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.

The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.

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