U.S. interest rate expectations have declined in recent months. Why then do we think inflation-protected government bonds are getting attractive? The Federal Reserve’s recent dovish tilt, against a slowing but growing economy, is key.
The Fed has put its monetary policy normalization on hold – putting downward pressure on interest rate expectations. We use 10-year U.S. government bond yields as a proxy for interest rates: Nominal yields and “real” yields (nominal minus inflation) have both fallen since late 2018, as the chart shows. We expect the Fed to hold off on any rate moves until at least the second half of 2019. Combined with still solid economic growth, this is likely to put further downward pressure on both nominal and real yields, and support bond prices (Bond prices move in the opposite direction of their yields). Fed officials have also signaled they may be willing to allow for modest overshoots above the central bank’s inflation target to make up for past undershoots. This could lead inflation-protected bonds to outperform their nominal counterparts–underlining our call for adding some exposure to Treasury Inflation-Protected Securities (TIPS) at the expense of nominal bonds.
The odds favor TIPS
We see TIPS (Treasury Inflation-Protected Securities) performing well in our base case of a Fed pause and ongoing, albeit slower global growth. But what if this call is wrong? Take the scenario of an economy faring better than expected and the Fed raising rates sooner. Higher inflation expectations would likely be a critical driver of the Fed’s gear shift. This scenario could bode well for fixed income instruments indexed to inflation, such as TIPS. Markets are pricing in a big undershoot of inflation versus the Fed’s target–as has been the case for much of the post-crisis period. The Fed’s favored gauge–which measures the expected inflation rate over the five-year period that starts five years from today–points to inflation of just above 1.8%. The recent change in the Fed’s commentary around inflation suggests the central bank would likely want to see inflation slightly exceed its target before considering a resumption of policy tightening–for fear of choking off economic growth.
We also find opportunities in inflation-linked bonds in the euro-zone. We expect the region’s inflation to remain well below the target set out by the ECB. Yet we see the current pricing of the macroeconomic outlook in inflation-linked product markets as overly pessimistic, particularly in comparison with recent rebounds in riskier European assets. We view inflation-linked debt as expensive in the UK. Fears about a no-deal Brexit and its potential hit to the British pound have driven up inflation expectations–even though we see the likelihood of such an outcome as low.
What is the case against inflation-protected securities within a fixed income portfolio?
The risk would be a renewed spike in U.S. recession fears-and growing market expectations that the Fed may cut rates. TIPS would likely under-perform nominal bonds in such a scenario, although we would still anticipate positive absolute returns. We see this scenario as unlikely in 2019, however, given the strength of the U.S. economy.
We see potential for TIPS to play a valuable role in portfolios in the near term.