Uncertain Links but Not Uncertain Policy – For Now
The third quarter of 2017 extended the pattern of non-directional swings in inflation readings and the breakeven inflation level of U.S. TIPS. Following a weak second quarter, 5-, 10-, and 30-year breakevens widened in the third quarter by about 12, 12, and 8 basis points1 (bps) respectively. The quarter delivered two upticks in year-over-year Headline Consumer Price Index (CPI) as July and August reversed the trend set by four consecutive declines since February. To be sure, since breakevens seem to be catching up to inflation reports, widening breakevens and higher CPI prints are two episodes of the same story. As we discuss below, uncertainty about the link between economic activity and inflation, coupled with other developments regarding the conduct of monetary policy, set the stage for a volatile TIPS market. This is not necessarily unfavorable for the asset class since TIPS compensate investors for higher-than-expected inflation, a valuable asset in an uncertain environment.
The underlying theme challenging TIPS has been stubbornly low inflation. CPI, excluding food and energy, has not yet begun to offset the declines of earlier in the year; and although Headline CPI increased to 1.7% in July and to 1.9% in August, this recent pick-up may be short-lived since it reflects the strong growth of fuel prices and shelter, which enter the CPI calculation through the Transportation and Housing components, respectively.
This brings us to the Federal Reserve (Fed) and its stance on inflation, economic activity, and policy. On September 20, the Federal Open Market Committee (FOMC) announced plans to gradually unwind its quantitative easing (QE) program. Since the Fed had been communicating this decision for a while, most investors focused on the Fed’s own expected path for the Federal Funds Rate (FFR). The upper bound of the FFR was left unchanged at 1.25%, but the dots show a lower median path for the target rate than at the previous meeting. This time the Summary of Economic Projections accompanied the announcement, and it is worth noting an upward revision of 0.2% in the median gross domestic product (GDP) projection and a downward revision of 0.2% in Core Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation.
The Fed’s actions suggest they consider low inflation a transitory phenomenon and that they expect that a strong economy, near full employment, will eventually lead inflation to reach or exceed their 2% target. However, a closer look at the Fed’s work reveals that the weakening of the relationship between the economy (the labor market in particular) and overall prices keeps them on their toes. The speech given by Chair Yellen on September 26 provides ample information about their concerns. For instance, if inflation remains low for longer than expected, the Fed’s credibility might be affected, potentially causing inflation expectations to drift. If this happened, actual inflation could become more volatile. Furthermore, the Fed carefully looked at the labor market and its muted impact on inflation thus far. In Yellen’s own words:
“Overall, I view the data we have in hand as suggesting a generally healthy labor market, not one in which substantial slack remains or one that is overheated. That said, the evidence does not allow for any definitive assessment, so policymakers must remain open minded on this question and implications for reaching our inflation goal.”
The Fed will adhere to its gradual tightening of rates, but it will remain ready to update their beliefs about the future behavior of inflation and adjust its stance accordingly.
We believe there is an additional layer of uncertainty: The composition of the new Fed Board. The Board has three of its seven seats vacant. Moreover, on September 6, Vice Chairman Stanley Fischer announced his resignation effective October 13. Once Fischer is no longer on the Board, a fourth seat will be vacant, and were Janet Yellen to be replaced when her term expires on February 2018, a total of five out of seven members, the Chair among them, would end up being chosen by the current administration. This rapid turnover is unprecedented. For the last couple of decades, and especially under Ben Bernanke and Janet Yellen, the Fed has strived to be transparent and to communicate its policies to markets as clearly as possible. Will the new Fed preserve this approach? In fact, one of the front runners for Ms. Yellen’s job is Kevin Warsh, a former Fed Governor who in May called for a “fundamental rethinking” of the Fed’s strategy, tools, governance, and communications. What kind of impact will a new Fed have on in the inflation risk premium and ultimately on TIPS? One could assume this means a more hawkish approach to policy, but as we learned over the years, it is not just the type of policy pursued that affects markets but also how it gets implemented. In this context, we do not know what fundamental rethinking really means.
Our TIPS strategies underperformed their benchmarks by about 10 bps in Q3 as we maintained a short duration position and real rates declined for the quarter. September mitigated some of the negative impact of the previous months thanks to an increase in real yields and a steepening of the curve, with 5-year and longer maturities rising between 2 and 10 bps. Consistent with the seasonal and auction patterns, we are entering the last quarter of the year with exposure to nominal 30-Year U.S. Treasuries. October brings the last 30-year nominal bonds auction, which usually requires a supply concession. Although the real yield curve tends to flatten toward the end of the year, our valuation work suggests an overweight in intermediate maturities and an underweight in long maturities. In addition, we are maintaining our short duration position.
We expect a rebound in inflation back to 2% trend levels. First, it has been 31 quarters since the end of the Great Recession, 29 of which added to GDP, producing an average annualized growth rate of 2%. Second, wage growth has picked up, as evidenced by the Atlanta Fed’s Wage Growth Tracker and by average hourly wages. Finally, alternative measures of inflation such as the Dallas Fed’s trimmed mean inflation, which removes positive and negative outliers, and the New York Fed’s Underlying Inflation Gauge that tracks fundamental trend inflation, show inflation closer to the Fed’s target of 2%.
The possibility of low inflation for longer than expected remains a challenge for TIPS, but it also helps make their valuations attractive. TIPS act like an insurance policy against unanticipated high inflation. Having this insurance is a good thing because it is priced attractively and the risks of higher inflation are rising. As we enter the final stretch of the year, we expect our time-tested strategies to uncover new opportunities, which have constantly delivered strong performance for our clients.
James J. Evans, CFA
Head of Quantitative Research
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IM-2017-10-24-4483 Exp. Date 01/31/2018
1Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.