Back in high school, I ran hurdles. I wasn’t very good, but got a spot on the track team because no one else wanted to do hurdles. I quickly discovered why: It’s hard, and a small mistake makes a huge difference in your time. Plus, the practices were brutal. The better you got, the higher the hurdles. Sprinters got to run their hearts out, and the distance runners got to experience the “runner’s high.” Hurdlers were lucky to avoid falling down. There were a lot of bruises.
There’s a good chance that the Federal Reserve is in for a few bruises in the months and years ahead as it raises the acceptable hurdle rate for inflation. After a long review of its policy framework, the Fed announced it is shifting to an “average inflation target” of 2% rather than a precise target. Rather than tighten policy pre-emptively when it sees inflation moving above 2%, it plans to hold interest rates steady for some time, allowing the economy to run a little “hot” at times, after being “cool” for a long time.
The immediate question that comes to mind is, “How will the Fed raise inflation?” After all, what good does it do to raise the target if you’ve been undershooting it for years? Core Personal Consumption Expenditures (PCE), which the Fed uses as its benchmark inflation measure, has spent most of the past 12 years below the 2% target.
Inflation has fallen short of 2% for most of the past decade
Source: Bloomberg. Personal Consumption Expenditures: All Items Less Food & Energy (Core PCE) (PCE CYOY Index), percent change, year over year. Monthly data as of 7/31/2020.
We believe the Fed will have a difficult time pushing up inflation, but inflation expectations are likely to continue to rise due to the change in the way the Fed will react to potential inflation. In fact, the Fed’s new stance is actually more focused on jobs than inflation. In his policy speech, Fed Chair Jerome Powell talked extensively about employment and the importance of the Fed doing all it can to support job growth. A part of the Fed’s review of its policy was a “listening tour” during which it engaged in discussions about the economy with communities across the country. The overwhelming message was that a strong labor market is important for improving the lives of individuals and the overall economy.
With that message and years of overestimating inflation based on the “natural rate” of unemployment, the Fed has abandoned its old framework and will not pre-emptively raise interest rates just because the unemployment rate falls below a predetermined level.
High unemployment is one of the Fed's biggest concerns
Source: Bureau of Labor Statistics. Civilian Unemployment Rate and Underemployment Rate, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons (U6 Rate), Percent, Monthly, Seasonally Adjusted. Shaded area indicates recession. Monthly data as of August 2020.
With the unemployment rate in double digits, pre-emptive rate hikes wouldn’t have been on the agenda anytime soon, anyway. However, the change is important. The Fed has thrown the Phillips curve (which describes the relationship between employment and inflation) into the dumpster. Whether it’s due to the effects of globalization, the decline in unionization, or the rise of service sector jobs over manufacturing jobs, wage growth has slowed relative to productivity growth over the past few decades. This has resulted in a decline in labor’s share of gross domestic product (GDP). Consequently, economic growth doesn’t necessarily translate into money in the pockets of those most likely to spend it—lower- and middle-income workers. Without a pocket full of money to drive up demand for goods and services relative to supply, a low unemployment rate doesn’t necessarily lead to inflation.
Inflation is not what it used to be
The Phillips curve is only one of the inflation metrics to get tossed. The truth is, the Fed and most economists are struggling with the breakdown in the relationship between inflation and the factors that were historically believed to drive it. The demographics of an aging population is a long-term, structural issue that appears to be keeping inflation low. Moreover, inflation expectations have moderated considerably since the 1980s. Once the back of inflation was broken in 1980s, things changed. The 1990s ushered in the “great moderation,” followed by recession and the crisis-packed 2000s.
Inflation volatility has moderated since the 1980s
Source: Bloomberg, using monthly data as of 7/31/2020. US CPI Urban Consumers year-over-year (YoY) NSA (CPI YOY Index).
All of these structural economic changes led to changes in the old economic relationships. Money supply growth, nominal GDP growth, employment growth, and even commodity prices are not nearly as useful in forecasting inflation as they were in the past. Here’s a quick look at each one:
1. Money supply growth: Not enough
Economist Milton Friedman famously said that inflation is “always and everywhere a monetary phenomenon.” It was gospel for years, but now money supply growth doesn’t correlate well with inflation. It is a prerequisite for inflation, but isn’t sufficient by itself. The money has to circulate in the economy—and that isn’t happening. Much of the money created since the onset of the COVID-19 crisis is sitting in checking and savings accounts, as wary consumers build savings.
Money supply growth is less likely to correspond with inflation than in the past
Source: Bloomberg. Inflation Composite Indicator and year-over-year (YoY) change in M2. M2 is a measure of the money supply that includes cash, checking deposits and easily convertible “near money,” such as savings deposits, money market securities, mutual funds and other time deposits. Monthly data as of 7/31/2020.
2. GDP growth has become a weaker driver of inflation
It’s a similar story with GDP growth. It’s often assumed that stronger growth will boost inflation, but in recent years that hasn’t been the case. Not only are nominal growth rates much lower now, but the sensitivity to inflation has also fallen.
During the past 30 years, GDP growth and inflation have become less correlated
Source: Bloomberg. Nominal GDP YoY and a Composite Inflation Indicator (GDPCURY Index). Monthly data as of 7/31/2020.
3. Commodity prices are a diminishing factor. Commodity prices show a similar trend toward diminished correlation with inflation. In the 1960s-1980s wholesale prices were a major driver of finished goods prices and therefore inflation. In the past 30 years, that relationship has weakened. Raw materials prices are a diminishing factor. Value-added costs are a more important factor in pricing.
“Inflation in the pipeline” doesn’t necessarily result in consumer inflation
Source: Bloomberg. US PPI Finished Goods NSA YoY% and Inflation Composite (PPI YOY Index). Monthly data as of 7/31/2020.
4. Currency has a weaker impact than in the past. Currency changes are another example of how inflation dynamics have changed. Throughout much of the period from 1960 to 1990, a 10% move in the dollar would lead to a change in the inflation rate of about 0.4%. In recent years, the impact has fallen by half. A weaker currency should raise inflation by boosting domestic growth as exports become more competitive, and raising the cost of imports. Even though trade is a relatively small proportion of GDP for the U.S., there was a strong correlation in years past. However, with increased domestic production of oil, globalization, and more widespread use of the dollar in financing global transaction, currency movements have had less impact. In other words, a weaker dollar may help lift inflation on the margin, but it’s not the solution to the Fed’s problems.
The dollar has less influence on import prices than in the past
Source: Bloomberg. Import Prices YoY and Inflation Composite (IMP1YOY% Index). Monthly data as of 7/31/2020.
5. Labor costs are still important, but their impact has declined. Labor costs still show a statistically significant correlation with inflation, but the relationship has declined over the years, as well. Still, using all of its tools to boost the labor market is probably the best shot the Fed has to achieve its goals.
The relationship between labor costs and inflation has declined in the past 30 years—but is still statistically significant
Source: Bloomberg. Unit Labor Costs YoY and a Composite Inflation Indicator (COSYNFRM Index). Monthly data as of 7/31/2020.
In sum, the Fed’s new framework is a concession to reality. It has relied on the Phillips curve and old relationships to try to forecast inflation, only to find out that it has overestimated inflation risks for decades. It will now take a patient approach and wait for inflation to show up before taking action in hopes of getting more people into jobs and supporting economic growth. The hurdles are very high. As a result, we expect the Fed to keep short-term rates near zero for several more years.
What this could mean for markets
The Fed’s new stance should have implications for the markets, including:
1. The yield curve likely will steepen. The initial reaction to the Fed’s policy announcement was a steepening in the yield curve. Long-term yields rose while short term yields remained pinned near zero. That’s a logical response to the signal from the Fed. However, within a few hours of Powell’s speech, bond yields gave back much of the gain, perhaps on the realization that it could be a long time before inflation actually shows up in a meaningful way. Nonetheless, we believe the curve will continue to steepen somewhat, as the market builds in a greater inflation risk premium and more concession for increased supply of Treasuries.
The Fed’s new inflation stance has steepened the curve
Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y30). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 30 year U.S. Treasury Note, then factoring the differences by 100. Source: Bloomberg. Daily data as of 9/9/2020. Past performance is no guarantee of future results.
2. Moderate inflation may favor credit exposure, but high inflation would not.
While investors often worry about the bond market in times of inflation, historically moderate inflation has been good for returns in bonds with credit exposure (that is, the possibility the issuer will default on payments or at worst, fail to return principal). Given the Fed’s easy policy stance, ample liquidity and the potential for economic recovery, credit spreads should continue to decline. History tells us that the riskier segments of the markets do best in an environment of low to moderate inflation. However, we’re not inclined to overweight lower-rated corporate or municipal bonds, as we do see scope for spreads to narrow further.
Average performance when inflation is at 2% or lower
Source: Bloomberg & Morningstar. Monthly data as of 6/30/2020. Each return listed is for the full time period available for each of the asset class indices shown. HY Credit = Bloomberg Barclays High Yield Credit Index; International Equities = MSCI EAFE NR Index; Preferreds = ICE BofA Fixed Rate Preferred Securities; IG Credit = Bloomberg Barclays U.S. Aggregate Corporate Bond Index; Bank loans = S&P/LSTA U.S. Leveraged Loan 100 Index; Long-term Treasuries = IbbotsonAssociates SSBI U.S. Long-Term Government TR; Munis = ICE BofA U.S. Municipal Securities Index; MBS = ICE BofA U.S. Mortgage Backed Securities Index; Intermediate-term Treasuries = IbbotsonAssociates SBBI U.S. Intermediate-Term Government TR; TIPS = Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index; Gold = Gold Dollar Spot; 1-month Treasury Bills = IbbotsonAssociates SBBI U.S. 30 Day Treasury Bills TR; Treasuries <1 year = Bloomberg Barclays US Short Treasury Index; Oil = Crude Oil – WTI; Commodities = LF98TRUU Index, NDDUEAFE Index, P0P1 Index, LUACTRUU Index, SPBDLL Index, U0A0 Index, M0A0 Index, LBUTTRUU Index, XAU Curncy Index, LT12TRUU Index, CL1 Comdty Index, SPGSCITR Index. Past performance is no guarantee of future results.
Historically, higher inflation has benefited “hard assets” such as gold and other commodities. However, it should be noted that periods of inflation above 4% were mostly seen in the “old regime” of 1960-1990.
Average performance when inflation above 4%
Note: Each return listed is for the full time period available for each of the asset class indices shown. For a description of the indexes used to represent each asset class, please see the Important Disclosures below. Source: Source: Bloomberg & Morningstar. IbbotsonAssociates SSBI U.S. Large Stock TR, Bloomberg Barclays High Yield Credit Index, MSCI EAFE NR Index, ICE BofA Fixed Rate Preferred Securities, Bloomberg Barclays U.S. Aggregate Corporate Bond Index, S&P/LSTA U.S. Leveraged Loan 100 Index, IbbotsonAssociates SSBI U.S. Long-Term Government TR, ICE BofA U.S. Municipal Securities Index, ICE BofA U.S. Mortgage Backed Securities Index, IbbotsonAssociates SBBI U.S. Intermediate-Term Government TR, Bloomberg Barlcays U.S. Treasury Inflation-Linked Bond Index, Gold Dollar Spot, IbbotsonAssociates SBBI U.S. 30 Day Treasury Bills TR, Bloomberg Barclays US Short Treasury Index, Crude Oil - WTI, Commodities (LF98TRUU Index, NDDUEAFE Index, P0P1 Index, LUACTRUU Index, SPBDLL Index, U0A0 Index, M0A0 Index, LBUTTRUU Index, XAU Curncy Index, LT12TRUU Index, CL1 Comdty Index, SPGSCITR Index). Monthly data as of 6/30/2020. Past performance is no guarantee of future results.
3. TIPS and emerging-market bonds may benefit. Treasury Inflation-Protected Securities (TIPS) and emerging-market (EM) bonds are not included in the charts above because of lack of data in the older era. However, these are two investments that could benefit now. The Fed’s dovish tilt should continue to put downward pressure on the dollar and support global growth—both . It’s a risky segment of the market, but one that has lagged in performance relative to other aggressive-income bonds.
Emerging market currencies have risen on the back of the Fed’s more dovish tilt
Source: Bloomberg. MSCI Emerging Markets Currency Index (MXEF0CX0 Index) and Bloomberg U.S. Dollar Spot Index (BBDXY Index). Daily data as of 9/9/2020. Past performance is no guarantee of future results.
from the Fed’s shift in stance. Year-to-date performance has been strong, but breakeven rates are still below the 2% target, leaving room for a further rally. The downsides are low-to-negative yields, but for investors concerned about inflation rising above 2%, TIPS can provide a hedge.
TIPS breakeven rates are still below 2%
Source: Bloomberg. U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index). Daily data as of 9/9/2020. Past performance is no guarantee of future results.
There are potential risks to our outlook. The first is the potential for a double-dip recession due to lack of fiscal relief. In general, we’re optimistic that the economy will continue to improve over the long run. However, the next six months are likely to be challenging if there’s no more fiscal relief from the federal government. Economic momentum is already ebbing and the virus is still active in many places. Until there is a vaccine or the virus has run its course, the potential for another contraction in growth near the end of the year is uncomfortably high. That could mean renewed flattening of the yield curve and wider credit spreads on the risk of rising defaults.
The second risk is around global growth. Markets are pricing in a global reflation, but there is room for concern. On the positive side, global trade is rebounding and a cessation of trade conflict with China is allowing for normalization of supply chains. However, the rise of COVID-19 cases in Europe, and ongoing spread in Latin America could hold back the economic recovery.
The third risk is the potential for the Fed to lose control of the yield curve. It seems unlikely, but if there were to be a bout of significant inflation pressure without a policy response from the Fed, it’s possible that long-term rates could rise more sharply than expected. With record amounts of deficit financing to be done and real yields in negative territory, it’s something to consider. We assume the Fed would use yield curve control to shift purchases to the long end of the curve to hold down rates, but it’s impossible to know for sure.
What investors should consider now
This is a good time to consider or . A bond ladder is a portfolio of individual bonds that mature at different dates. A steepening yield curve would allow you to reinvest maturing bonds at higher yields and earn more income over time. (If yields fall, it’s true that you’ll be reinvesting at lower interest rates, but you’ll already have some higher-yielding bonds in your portfolio from when you initially put the ladder together.)
Barbells are another potential strategy. With a bond barbell, you hold some short-term maturities and some longer-term maturities. This is another way to lock in yields, although investments at the long end can be volatile. We often suggest barbells as a way for investors who have been on the sidelines in cash to work into a ladder. They can add rungs on the ladder over time.
We don’t expect a big rise in 10-year Treasury yields from current levels, but we would consider adding some intermediate to longer-duration bonds if yields push up toward 1%. At current levels, the risk/reward on longer-duration bonds is not that attractive, although holding some long-term bonds can provide both added income and a hedge against a bout of volatility in risk assets. Overall, we prefer keeping average duration somewhat below that of the typical benchmark, given the low level of yields.
We suggest a neutral weighting to corporate bonds. The risk/reward balance looks reasonable, with yield spreads versus Treasuries still slightly above long-term averages. However, we continue to suggest staying up in credit quality due to the likelihood of rising defaults and downgrades.
We see value in highly rated municipal and corporate bonds for core bond holdings. For investors willing and able to take more risk, we favor preferred securities and emerging market bonds.