Demand rises for inflation hedges as perceived risk grows
Demand for US inflation-protected bonds has intensified as some investors look to insure their portfolios against a spike in consumer prices when economic activity rebounds from the coronavirus crisis and governments reckon with massive increases in borrowing.
The mounting interest in Treasury inflation-protected securities — US government bonds whose yields are adjusted in line with consumer price inflation — has sent their yields close to record lows in some cases.
The yield on 30-year Tips currently hovers just shy of an all-time low of minus 0.26 per cent, according to Tradeweb data. Five and 10-year Tips yields have also dropped, closing near levels last seen in 2013 and 2012, respectively.
More than $5bn flowed into funds investing in Tips over the four weeks ending July 8, according to data from EPFR. That reversed outflows seen during March and April, the figures show.
Growing appetite for these securities comes as market measures of inflation expectations have remained subdued and well below the US Federal Reserve’s 2 per cent target.
While the 10-year break-even rate, which is derived from Tips, has climbed from its lows in March, it remains at just 1.4 per cent. A swap rate that measures expectations of the average level of US inflation over five years, starting five years from now, indicates a similarly downbeat view, at 1.8 per cent.
The current pricing of inflation-linked bonds makes it relatively affordable for fund managers to protect their portfolios against a longer-term pick-up in inflation.
“If you want inflation protection, Tips are the best-priced asset today,” said Seema Shah, chief strategist at Principal Global Investors, noting that the price of gold, another favourite inflation hedge, has ballooned.
While few investors fear an immediate resurgence in inflation, what has become the “concern du jour”, according to Steven Blitz, chief US economist at TS Lombard, is what happens when a recovery starts to take hold.
“I do not expect inflation for the next 12-18 months,” he said. “After that, I could see the economy having a higher inflation bias.”
Investors have watched warily as the Fed has shifted its stance on inflation. On Wednesday, Philadelphia Fed president Patrick Harker echoed comments made by Fed governor Lael Brainard a day earlier advocating for the central bank to let inflation overshoot the Fed’s target.
“I am supportive of the idea of letting inflation get above 2 per cent before we take any action with respect to the fed funds rate,” Mr Harker said in an interview with Bloomberg Television.
The most recent data showed that core PCE, the Fed’s favourite inflation gauge, dropped to 1 per cent on a year-over-year basis, down from 1.7 per cent at the start of the year.
Taking these factors together, alongside the unprecedented stimulus measures from the central bank and a massive increase in government spending aimed at shoring up demand, the justification for inflation hedges has grown, investors say.
“I think you’re going to see inflation rise and the Fed and other central banks won’t be proactive about withdrawing stimulus,” said James Athey, a bond portfolio manager at Aberdeen Standard Investments.
Even investors who are deeply sceptical about the prospects of runaway consumer prices acknowledge the benefits of seeking out protection against such risks.
“It is always wise for investors to be mindful of risks that may not be a likely scenario,” said Brett Wander, chief investment officer at fixed income at Charles Schwab. “Having some inflation protected securities in your portfolio makes sense even if inflation is an unlikely scenario.”