One question we get a lot from clients is about the future of inflation. It’s a big question and a complex topic and like most in that category, it’s not easy to answer with any certainty. But there are a few tools we can turn to for help.
First off, this is the big question the Federal Reserve has to answer every day. They have what’s called the dual-mandate: price stability and full employment; i.e. control inflation and create conditions to put as many people as possible to work. So, the Fed spends at least half its time trying to answer this inflation question.
With higher inflation, comes higher interest rates and vice versa. And the Fed’s forecast for interest rates, as we’ve noted recently, is pretty tame. They have even said they would allow inflation to run over the 2% target for some period of time to have “average” inflation of 2%. We don’t really know what that means because of unclear timing, and because 2% is pretty low historically. But there is nothing magic about 2%. They could change their target to 3% or 1% and then come up with some complicated justification for either.
But we believe the wisdom of crowds and the pricing of market instruments can also hold a lot of info. So, let’s take a look at the yield curve. This is usually measured by plotting the different yields of all the different treasury maturities at a given point in time, starting with 2-year and moving out to 30-year bonds. Remember, the Fed only sets the overnight rate; the very shortest maturity and the rest of the curve is market driven. With the 10-year today at 1.27 and the 30-year 2.04, we can say the market is not currently predicting much in the way of inflation.
There is another more specific rate that is adjusted daily, via market pricing, that is actually intended to predict inflation directly by market participants. That is the TIPS rate; Treasury Inflation Protected Securities.
The current average rate on long TIPS is negative. Sort of unsettling… you have to pay to lend your money via this bond. Which would mean market participants are predicting deflation, or at least disinflation, over the long term. This chart is all based on 10-year plus TIPS maturities.
We believe this is why the Fed is willing to be very loose with policy. So, when I see headlines today about interest rates heading up, and the economy heating up, and inflation on the doorstep, I kind of scratch my head. We know that the Fed is not always right, and we know that market participants can make mistakes. But when you take into account how much larger the bond market is than others and how many participants there are, all making their best educated guesses about this, I wouldn’t go too far in on the inflation trade. We may see interest rates rise a bit from these extremely low levels and some moves upward in the inflation measures, but it will help to keep the long end of the curve in mind.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price index.