Inflation Bonds Are Betting on Team Transitory
(Bloomberg Opinion) -- Fear of inflation has a partisan flavor: People tend to feel better about economic prospects when their political party is in power and worse when it isn’t.
If investors behaved that way, dread would be registering in the corner of the credit market where the fearful can buy insurance against runaway inflation. After all, the U.S. Personal Consumption Expenditure Core Price Index and Consumer Price Index Urban Consumers Index climbed to 30-year highs of 4.1% and 6.2%, respectively, in 2021. Republicans are using the specter of unchecked inflation to bash President Joe Biden, and plenty of Democrats are jittery, too.
It isn’t happening. Short- and long-term obligations, representing $29 trillion of U.S. debt, including Treasury Inflation Protected Securities created 25 years ago as an inflation hedge, are collectively calculating a CPI over the next 30 years that won't amount to even a percentage point above the 21st-century average of 2.2%.
The breakeven rate, or gap between the yield of an inflation-linked bond and the yield of a traditional Treasury security, doesn't signal anything close to alarm over inflation. The 30-year breakeven rate, measuring the difference between 30-year TIPS and the benchmark 30-year Treasury, is 2.32%, less than the breakeven rate between 2009 and 2013, when the U.S. economy was struggling to recover from the 2008 financial crisis, according to data compiled by Bloomberg.
Breakeven rates historically are higher for longer periods than shorter durations as investors anticipate paying more for goods and services in the distant future. Sure enough, that's the outcome when the 10-year breakeven rate is compared to the two-year breakeven rate between 2010 and 2020. But in 2021, the two-year rate exceeded the 10-year rate, showing that investors are betting that inflation will peak during the next two years and then subside for the next eight. Federal Reserve Chair Jerome Powell says as much in his routine testimony to Congress.
The issuance of TIPS, which now total more than $1.6 trillion on an annual growth rate of 25%, also shows a relative decline compared to the rest of the Treasury market. If inflation is the existential threat to prosperity asserted by so many commentators, the demand for TIPS should be increasing in lockstep with the exchange-traded funds created to purchase them. While the iShares TIPS ETF, the largest measured by assets, saw a 45% increase in demand during the past 12 months, newly issued TIPS were 34 basis points less as a percentage of total Treasury sales during the same period, according to data compiled by Bloomberg.
None of this comes as a surprise in the most recent Survey of Professional Forecasters by the Philadelphia Federal Reserve Bank, which shows inflation decelerating beyond next year. A. Gary Shilling, my Bloomberg Opinion colleague and a former official at the Federal Reserve Bank of San Francisco who subsequently was twice ranked as Wall Street's top economist in polls by Institutional Investor, is sanguine about inflation. In his most recent column, Shilling predicted that the U.S. will “return to low inflation and interest rates” with commodity prices resuming their long-term decline.
The proof, according to Shilling, will be the continuation of the 41-year-old bull market in bonds, where the benchmark 30-year yield plunged to 2% from 14.6%, with Treasuries outperforming the S&P 500 Index on a total return basis. “This bond rally may well continue taking the yield back to its early 2020 pandemic low of 1.0%,” Shilling wrote. The yield on the benchmark 10-year Treasury, a barometer of confidence in the Fed, is 0.7 percentage points less than it was in 2017, the last time unemployment declined to 4.6%.
The bond market reflects another misfortune that justifies the Fed's willingness to tolerate incipient price increases throughout the economy before tightening credit. Even after the unemployment rate declined to 4.6% from a high of 14.8% during the Covid-19 pandemic last year, the labor participation rate still is 61.6%, well below the pre-pandemic high of 63.4% and an indication that almost 6 million people, or the equivalent of Maryland, have left the labor force and stopped looking for a job.
Such distress is anything but inflationary.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matthew A. Winkler is Co-founder of Bloomberg News (1990) and Editor-in-Chief Emeritus; Bloomberg Opinion Columnist since 2015; Co-founder of Bloomberg Business Journalism Diversity Program in 2017. During his 25 years as Editor-in-Chief, Bloomberg News was a three-time finalist and winner of the Pulitzer Prize for Explanatory Reporting and received numerous George Polk, Gerald Loeb, Overseas Press Club and Society of Professional Journalists and Editors (Sabew) awards.
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