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Fixed-Income Insights

Here's an assessment of the factors fueling investor concerns—and the potential implications for fixed-income markets.

 

In Brief

  • Some fixed-income investors appear to be concerned about prospects for accelerating U.S. inflation. The worries may be fueled by three factors:
  • First, a May report from the Bureau of Labor Statistics showed consumer-level inflation advancing at the fastest pace in more than a year;
  • Second, geopolitical turmoil has sent the price of crude oil higher in recent months; and
  • Third, business executives and others anticipate a faster rate of wage growth for U.S. workers in the months to come.
  • The key takeaway—Whether or not prices are actually rising, the factor that has the greatest impact on asset prices is investors’ expectation of future inflation. Those who think that prices of goods and services may be headed for a sustained upswing may wish to consider inflation-protection strategies.

 

Investors’ concerns about inflation recently have been rekindled by a trio of factors: a larger-than expected increase in the annual rate of consumer prices in May, rising oil prices sparked by geopolitical turmoil, and fear of wage pressures. Structural support for inflation concerns seems to be provided by the expansion of monetary liquidity resulting from the Federal Reserve’s three quantitative easing (QE) programs. 

But one of the architects of QE, Fed chairwoman Janet Yellen, seemed to downplay the market’s inflation worries. She characterized recent inflation data as “noisy” at a press conference on June 18,1 and not truly indicative of a sustained uptrend in prices.

Should investors tune out the “noise” that Yellen perceives, or adjust their portfolios to anticipate an era of rising inflation?

Oil Spikes and Wage Worries
First, let’s take a closer look at some of the developments that have worried investors. The Bureau of Labor Statistics (BLS) reported on June 17 that the Consumer Price Index (CPI) rose at an annual rate of 2.1% in May, the fastest monthly gain in more than a year. In the last three months, the core CPI, which excludes food and energy prices because of their volatility, rose at the fastest pace since the 2008–09 financial crisis. It is not surprising that inflation expectations, as measured by breakeven rates on five- and 10-year Treasury Inflation-Protected Securities (TIPS), have recently climbed.

Investor concerns were aggravated by Yellen’s commentary after the Fed’s policy meeting on June 18. The morning after Yellen’s offhand comments about the “noisy” CPI number, the Treasury yield curve steepened as longer-term Treasuries fell in price and rose in yield. Market commentaries revealed investor worries that Yellen may be underestimating the risk of rising prices—and that the Fed may already be falling behind in reducing the risk of higher inflation. 

Investors also are wary of global and domestic developments that could spark inflation. Rising oil prices are of particular concern. Supply disruptions as a result of geopolitical events in Ukraine and Iraq could produce a meaningful spike in oil that could dampen growth expectations as well as fuel inflation expectations. Even though the United States has increased production of both oil and gas, a prolonged supply disruption will likely influence U.S. prices as well. Higher oil prices can be quickly extrapolated to their impact on manufactured items (e.g., plastics, fertilizers) and essential services (truck and rail deliveries).

Wages are another area that could include risk. If longer-term unemployed Americans do not get jobs because they do not have the skills that are in demand, then the available supply of labor may be smaller than unemployment numbers suggest. Reports of increasing job openings that are unfilled because of an employer’s inability to find workers with the proper skills may eventually be resolved as companies offer higher wages to attract qualified workers who may be working for less elsewhere. 

Higher minimum wages also hold potential for wage inflation. While an increase at the federal level is unlikely, there has been movement on other fronts. President Obama recently issued an executive order lifting minimum wages for federal contractors. A number of states and cities have introduced their own wage floors as well. Should higher minimum wages become nationally adopted, it may risk the beginnings of a wage-price spiral that could produce long-term inflation problems.  

Perception versus Reality
In aggregate, conditions seem to be building to support, if not fuel, an increase in inflation. An examination of each concern reveals a reality of increased inflation risk that demands investor awareness, but not yet an accelerating trend that would prompt Fed action. But we don’t need to have an actual inflation problem to have increased fears. Investor perceptions of higher inflation may have a greater impact on investments than inflation numbers themselves, or even any related Fed actions.

The May CPI number is concerning because its increase was broad-based. However, it is unlikely to be reflected anytime soon in the Fed’s preferred inflation measure, core personal consumption expenditures (core PCE).  The largest component in the CPI is shelter, at 32%. Accordingly, the CPI number was heavily influenced by the past year’s increases in housing costs. The PCE includes shelter at a 15% weighting, which explains in part why the May core PCE was 1.5%, lower than the Fed’s inflation target of 2% and lower than the May core CPI reading of 2.0%. Janet Yellen’s characterization of “noise” surrounding the CPI number may have been related to the impact of shelter, especially since a key concern of the Fed is housing, which has weakened recently.

Analysis by the San Francisco Federal Reserve also suggests that, historically, “when CPI inflation exceeds [PCE] inflation, it tends to slow toward the latter to close the gap.”2 So, among other reasons, we can continue to expect CPI to be higher than PCE, until rising shelter costs abate, and we also can expect the Fed to continue to focus on core PCE as its inflation benchmark. This leads us to conclude that higher CPI is not likely to affect Fed policy—policymakers would likely react only to core PCE figures above 2.0% for several months—but numbers of that magnitude do not seem imminent. 

Rising oil prices, courtesy of a supply shock, also could amplify inflation concerns. However, the adverse impact to global growth of such a development may be a bigger concern. Expect the Fed, and possibly other major central banks, including the European Central Bank, Bank of England, and Bank of Japan, to provide liquidity if an oil spike shocks markets and increases concerns of both higher inflation and slower growth. If there is a sustained upturn in the price of oil, its secondary effects and the additional monetary stimulus may increase inflation concerns. But the central banks’ response at this stage in global recovery will rightly focus on offsetting economic shock and promoting growth. Under such a scenario, expect inflation concerns to increase, and the yield curve to steepen while a flight to quality boosts Treasury prices at the expense of credit-sensitive securities.

Recent wage growth, up 2.1% in May versus a year earlier, according to the BLS, may also concern some investors. The Wall Street Journal recently cited a survey that showed U.S. chief financial officers expect wage and salary gains of 3.0% over the next 12 months. Such gains could cause inflation-wary investors to respond, resulting in slightly lower prices on high-quality bonds and slightly higher yields. Yellen, on the other hand, may welcome such figures. In mid-June, for example, she commented, “My own expectation is that…we will see wage growth pick up at some point where…nominal wages are rising more rapidly than inflation.”2 While this may be appropriate monetary policy, some investors may feel such an approach assures Fed policy will be late in addressing inflation risks. Again, prices of longer-term high-quality bonds could be compromised.

Investment Implications
Interest rates on long-term bonds have yet to respond to recent indications that the best (i.e., lowest) inflation news may be behind us. Increases in headline CPI, oil prices, and even wages are not close to alarming levels and thus are unlikely to provoke the Fed to shift policy anytime soon. But once again, the market impact lies not in the current inflation numbers but with investors’ expectations of the future. A combination of increasing inflation and apparent unconcern among policymakers could influence investments before announced inflation numbers reach concerning levels. 

The upshot of all this is that while a dramatic increase in inflation does not seem imminent, an increase in inflation expectations could unfold quickly, hurting long-term, high-quality bonds and benefiting securities that profit from rising inflation expectations.  

 

1”Transcript of Chair Yellen’s Press Conference,” Federal Reserve, June 18, 2014.
2Yifan Cao and Adam Hale Shapiro, “Why Do Measures of Inflation Disagree?” Federal Reserve Bank of San Francisco, December 9, 2013.
3” Transcript of Chair Yellen’s Press Conference,” Federal Reserve, June 18, 2014.

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver investment returns that exceed the rate of inflation in the U.S. economy and current income by investing primarily in inflation-linked derivatives and inflation-indexed fixed income securities.

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