Inflation is a bond investor’s worst enemy. Higher costs erode the purchasing power of a bond’s future cash flows, which pushes bond yields higher as investors demand more yield to compensate for inflation risk. The following chart illustrates how inflation growth and bond yields move together. Inflation typically declines during recessions (shaded in grey).
Where is inflation now? Inflation naturally trends higher coming out of a recession, which is where we are now, as the demand for goods and services recovers and confidence builds. First comes inflation expectations, but actual inflation is slower to follow. As shown in the chart below, Treasury-inflation protected securities (TIPS) are Treasury bonds where the principal value is tied to inflation movement, so TIPS valuations are an excellent proxy of where investors see inflation going.
There are multiple ways to measure inflation, but core inflation is what the Federal Reserve watches closely. Core inflation excludes the food and energy sectors, which tend to be volatile. Recently the Fed shifted its inflation target to an average inflation target of 2%, meaning they will allow inflation to run above 2% to make up for periods where inflation is below 2%.
The good news for bond investors is that while both rates and inflation are likely to move higher as the economy recovers, it will take time. In fact, if inflation were at 2.5% every month going forward, it would take until March 2022 for average inflation to reach 2.0%.
All this suggests investors should position for rising inflation but not runaway inflation or an aggressive response from the Fed. This includes staying modestly short duration, underweight Treasuries, and an overweight to spread sectors (e.g., MBS and credit) and assets that do well in a rising inflation environment, such as TIPS.
Originally published by Sage Advisory, 2/23/21
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