U.S. Inflation: The Bond Market Weighs In

Mid Week Bond Update

U.S. Inflation: The Bond Market Weighs In

Signs of economic strength are plentiful. But the inflation outlook is pulling back – at least according to the market for U.S. Treasuries.


Signs of economic strength are plentiful, with Q2 GDP up an annualized 4.2%, personal consumption up 4.0%, June core consumer prices up 2.3%, July’s unemployment rate stable at 3.9% and job openings for June measured at 6.66 million.

But instead of rising apace, the outlook for inflation is pulling back – at least according to the market for U.S. Treasuries.  Breakeven inflation rates, which are indirect measures of the Treasury market’s expectations for rising prices, show those expectations have been moving downward slightly for the five years ahead, and are now just below the Fed’s 2% objective.  And the nearer-term 2-year breakeven rate is now about 1.75%, after having been above 2% as recently as the end of March 2018.

 

Source: Bloomberg, August 7, 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.

 

These readings are consistent with the Fed’s preferred measure, Core Personal Consumption Expenditure inflation, which will be released toward the end of the month. It appears that the Fed may concur with this assessment. In the statement accompanying the FOMC decision to leave its target rate at 2.0%, core inflation was described as remaining near 2%, rather than rising.

Breakeven rates aren’t predictions; instead, they reflect each day’s changeable expectations about the future. But the signal they’re sending about today’s expectations are clear nonetheless.


On the rise: U.S.  Investment-Grade Energy Debt

The energy sector of the bond market is dominated by offerings in the high-yield space .  But investment-grade energy has attracted notice as well recently. Over the past three months, the sector has handily outperformed both the Bloomberg Barclays U.S. Aggregate Index and  Corporate (investment grade) Index in terms of total return: While the U.S. Aggregate Bond Index rose 0.70% during the three-month period ended August 7, 2018, the U.S. Corporate Index rose 1.18% and the S&P U.S. Investment Grade Corporate Bond Energy Index returned 1.57%, 39 basis points better than the general investment-grade index.

Of course, gains over  such a short period might not be indicative of long-term differential return. But these results line up with the overall good news in the U.S. Energy sector, where balance sheets have been bolstered over the past few months by rising energy prices – and which have been used by companies in the sector to pay down debt and take advantage of already-built exploration, production and transportation infrastructure.

 

Source: Bloomberg, July 31, 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.

 

On the slide: Turkey Sovereign Debt

As of the end of the trading day on August 7, bids for Turkey’s 5-year government debt were running at about 21%, up dramatically from the 11.88% yield at the start of 2018 – despite the attempt by the central bank on July 17th to arrest the rise in yield and plummeting  value Turkish lira. The lira itself, as of August 7, traded at 5.258 per U.S. dollar,  having pulled back from its low of 5.422 per dollar on August 6th in reaction to a sale of U.S. dollar swaps by the Turkish central bank.

In this situation, the typical reaction of a country’s central bank would be to ratchet up its main policy interest rate; appeal to the International Monetary Fund (IMF) for emergency relief; and/or  impose capital controls as a last resort. However, the matter is complicated by Turkey’s bitter policy dispute with the EU and the U.S. over Syria, refugees, the detention and trial of American pastor Andrew Brunson;  and dueling economic sanctions.

The IMF hadn't received a request for assistance as of the close of business on August 7; Turkey's central bank has made no policy changes; and there have been no statements from either the president’s office or from the central bank about the current situation.

Indeed, the central bank, whose administration is widely perceived as an ally of the newly re-elected government, has instead clearly stated that it will encourage low interest rates to stimulate growth.  A Turkish trade delegation is scheduled to meet with U.S. trade officials in Washington this week, which could break the logjam  on at least some of these issues.

Meanwhile, advocates of central bank independence now cite Turkey as a cautionary tale worth watching.

 


All data Source: Bloomberg August 7, 2018, or on their respective indicated dates.

Definitions:

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.

The 2-year and 5-yearbreakeven inflation rates are measures of expected inflation derived from nominal Treasury securities and their inflation-adjusted counterparts—inflation-protected TIPS securities.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.

The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers. The US Corporate Index is a component of the US Credit and US Aggregate Indices.

The  S&P U.S. Investment Grade Corporate Bond Energy Index measures the total return of investment-grade bonds in the energy sector.

 

 

 

Top

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

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.

Diversification does not guarantee a profit or protect against loss.

Active management does not ensure gains or protect against market declines.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK & Switzerland) this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority.

In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.

Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information Documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.