Download Reflections on Reflation—Why This Time Feels Different for TIPS

CIO INSIGHTS
SECO N D Q UARTER 2017 – FIXED I N CO M E
Reflections on Reflation—Why This Time Feels
Different for TIPS
Inflation-protection strategies and securities, including Treasury inflationprotected securities (TIPS)1, have been the subject of prior Insights. But there’s
a difference this time, and it’s not just President Trump and his policies.
Global financial markets experienced
several shocks last year, not the least of
which was the election of President Trump
and the resulting reflation expectationfueled risk market rallies. We discuss the
“Trump Bump” and its potential aftermath
in our CIO Insights Introduction piece this
quarter (“Risk-Market Rallies Meet Policy
Implementation Realities”).
Trump Could Bump More Than Growth
Underlying the Trump Bump were key
potentially inflationary/reflationary tenets
of “Trumponomics”—the Trump team’s
package of policy proposals seeking to
stimulate stagnant U.S. economic growth.
Trumponomics proposes to add significant
fiscal stimulus at a time when monetary
policy remains stimulative and the U.S.
economy appears to be significantly
reducing some of its slack, particularly in
the labor market. It’s fair to ask whether
more fiscal stimulus would improve
economic growth, or simply drive up prices.
A rebound in inflation expectations actually
started last summer, after China- and
oil-related deflation fears in the first half
of last year. A key measure of the bond
market’s inflation expectations is the 10year breakeven2 rate, the yield difference
between 10-year U.S. Treasury notes and
10-year TIPS. This rate rose from 1.34%
in July 2016 to 2.08% in January 2017, a
significant six-month move, but still below
the rate’s historical average, which is closer
to 2.30%. This illustrates an important
point—inflation is trending higher, but it
isn’t high yet. Our concern isn’t so much
with present inflation levels as it is with the
extended upward trend in some measures
and the potential for even higher inflation
in the coming year or two.
IN-FLY-92296 1704
Recent Trends Suggest Higher Prices
We’ve warned about higher inflation before.
What’s different this time? An obvious
answer is Trumponomics, as explained
earlier. But that’s not the only new factor. In
broad terms, the global economy appears
to be changing, and recent trends suggest
higher prices. More specifically, we see:
• Synchronized global economic
growth. The U.S., Europe, Japan, and
China are improving at the same time.
• No more deflation fears. Post-2008,
deflation was a periodic concern.
No longer.
G. David MacEwen
Co-Chief Investment Officer
“We believe there’s more inflation
risk in our future than what’s
priced into the bond market.”
• Goods costs starting to increase.
In recent years, increasing service
costs, such as medical expenses, have
boosted inflation more than goods. Now
goods costs are ticking higher too.
• U.S. wage pressures. Declining slack
in the U.S. labor market has started to
drive up wages.
• U.S. inflation appearing to outpace
U.S. economic growth. Annual
headline inflation is over 2%, while
economic growth is still struggling to
exceed that level.
Total Return Opportunity for TIPS
For these reasons, and others, we believe
there’s more inflation risk in our future
than what’s priced into the bond market,
enough to invest a small portion of
portfolios in TIPS and/or other inflationprotected securities. In our view, if
breakeven rates are near 2% at the
time of investment, there’s an opportunity
for TIPS to outperform high-quality
nominal bonds if inflation expectations
move toward their historic 2.30% average
or higher.
©2017 American Century Proprietary Holdings, Inc. All rights reserved.
Inflation-linked debt securities issued by the
U.S. Treasury.
1
The difference between the nominal yield (usually
the market yield, which includes an inflation
premium) on a fixed-income investment and
the real yield (with no inflation premium) on an
inflation-linked investment of similar maturity and
credit quality.
2
Generally, as interest rates rise, bond values
will decline. The opposite is true when
interest rates decline.
The opinions expressed are those of
G. David MacEwen and are no guarantee
of the future performance of any American
Century Investments portfolio.
For educational use only. This information is
not intended to serve as investment advice.
Non-FDIC Insured • May Lose Value • No Bank Guarantee