Are US inflation expectations an investable opportunity?
'INTEREST rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy.'
These are the words of Federal Reserve chairman Jerome Powell used last month to describe the monetary outlook in a speech at the Economic Club in New York. To many in financial markets, this represented a distinct change from his assertion only a month ago that interest rates were “a long way from neutral”.
Stock and bond markets responded positively as investors spoke of a potential pause in the path of future interest rate rises. We're not so sure. The language seems more likely to the sizeable, and well known, uncertainty in determining where r-star (the interest rate that neither stimulates nor dampens growth) exactly is. We're not sure this should be read as an attempt to re-calibrate market expectations of future rate hikes as some seem to have done.
With inflation close to central bank targets, we still observe that investors are quite relaxed about the potential risks of inflation overshooting expectations. Why?
Post-crisis inflation has been persistently low across geographies. While most central banks operate under an inflation target, we currently have an extensive period where inflation has been falling short of these targets by a wide margin. As a result we have seen that in the period of 2012 to 2016, ‘expectations' of future inflation have gradually been drifting lower.
For very good reasons it has been almost a decade where investors have not had to worry about inflation overshooting targets or even expectations. But with incoming inflation data closer to central bank targets, and wages starting to show signs of the increasingly scarce supply of willing workers, are investors becoming complacent?
In the US, where the unemployment rate is already at historical lows and the labour market continues to tighten, one would expect inflation risks to increase. Long-term inflation expectations based on the consumer price index (CPI) are currently about 2 per cent, up from levels closer to 1.5 per cent where it was two years ago.
However, it has usually been north of 2.5 per cent over the last decade. These expectations would normally average a bit above the central bank target. In this case where the Fed has a dual mandate with an inflation target of 2 per cent on private consumption expenditure (PCE), the consumer price index equivalent would be closer to 2.4 per cent.
Add on a small compensation for the risk of unexpected inflation (we call this the 'inflation risk premium') and we get to an average of inflation expectations in capital markets that have been fluctuating around 2.5 per cent. An obvious question now is whether investors should demand a higher or below-average compensation for that inflation risk at this point in time. For example, should that compensation be somewhat higher now given that the Fed's independence is being challenged by comments and opinions from the US President?
More recently, with energy prices dropping by more than 30 per cent in a short space of time, investors have re-valued inflation-linked products lower as well. An energy shock can have a large impact on near term inflation prints, since energy makes up 8 per cent of the inflation basket.
However, its lasting impact on inflation for the next 10 years should be non-existent, as such shocks would mostly roll away within a year from base effects. In other words, energy would have to keep on falling at the same rate for inflation to stay at same level.
Given that real interest rates have been rising throughout 2018, with 10-year real interest rate now at 1.1 per cent, does this provide an opportunity to switch from US Treasuries into inflation-linkers?
As inflation expectations normalise, while investors are still somewhat conditioned on the past decade, we feel that the recent drop in inflation expectations could provide a relative value opportunity between US treasuries versus inflation-linked treasuries.
:: Jonathan Sloan is director at Barclays Wealth and Investments NI