December 2019 Macro Commentary
Bond Markets Have Discarded the Prospects of Higher Inflation
Outlook for Long-Rates Now Biased to the Upside
Investors Should Look for Cheaper Hedges
by Sanjay Khindri, CFA
The 10-year U.S. Treasury Yield has predictably tracked the roll-over in U.S. GDP growth for 2019 (see Chart 1). This decline, coupled with benign corporate credit risks, has helped drive Treasury and Investment-Grade bond markets to a more than 8.5% total return so far this year (> 2.5 standard deviation move). Historically, this magnitude of high-grade fixed income returns would be associated with a deeper economic downturn and a bear market for equity securities. This time has been very different, however, and it’s important to understand the drivers to gauge the outlook for markets going forward.
Chart 1: Real U.S. GDP Growth (blue) and Nominal 10-Yr Treasury Yield (red)
Source: Federal Reserve Bank of St. Louis
Three main components comprise the yield of the 10-year Treasury rate: the average expected level of the Fed Funds rate over time, the average level of expected inflation over time, and the additional yield investors require for holding a long-term debt instrument as opposed to rolling-over shorter-term securities. The magnitude of recent Fed Funds rate reductions has been fairly modest, with the Fed describing policy as being on the side of accommodation and on hold. Further, research has confirmed the sustained lack of a term premium in bond markets, most likely driven by structural economic factors. Therefore, the primary culprit contributing to the magnitude of the decline in the 10-year has been a decline in the expected rate of inflation.
We can confirm this by looking at Chart 2, which compares realized inflation, as measured by the Fed’s preferred gauge, with expected inflation in the future, as measured via TIPS markets. The most important part of the graph is the gap between the blue line and red line, which can be thought of as an inflation risk premium that investors require in order to hold longer-dated bonds. This gap has collapsed more recently, indicating that markets have given up on the prospects for sustained higher inflation, despite the Federal Reserve indicating a symmetric objective for its 2% inflation target and more room to lower rates if this objective is not met.
Chart 2: Realized Inflation (red) Versus Future Expected Inflation (blue)
Source: Federal Reserve Bank of St. Louis
Forward inflation expectations have predictably declined alongside realized inflation. TV commentators and politicians generally focus on the month-to-month numbers, but it’s important to realize that inflation is a lagging indicator of economic activity. Looking forward, there are leading indicators of inflation which are pointing to upside risks.
U.S. productivity growth has been solid the last two years due to 1) a strong global economy in 2017 and 2) the 2018 corporate tax rate reduction. Both of these factors drove higher business investment. Since late 2018, however, global trade has contracted, driving business investment into negative territory. Importantly, private sector investment is a strong leading indicator of productivity growth (see Chart 3), which itself directly determines unit labor costs. The bottom-line is that given an expected weakening in productivity growth and barring a collapse in aggregate demand, raising average selling prices is the remaining lever corporations have to maintain profit margins.
Source: Gallatin Capital Management
The investment implications of all of this are two-fold: 1) With effectively no inflation risk-premium built into bond prices and the risks to realized inflation now to the upside, the outlook for fixed-income returns are skewed to the downside, even assuming we stay in a low-growth environment; and 2) Investors have effectively already realize substantial hedging/return benefits from owning fixed-income, but at a time when equities never materially retreated from all-time highs. This implies that it would take a meaningful leg-down in economic growth, i.e recession risk, to get Treasury yields to test or pass through 2019 lows. From an asset allocation perspective, going forward the hedging benefits of owning duration (i.e. high-grade bonds) will be sub-par.
Investors should be looking to cheaper avenues for equity hedges and portfolio stabilizers, such as safe-haven currencies and/or volatility derivatives.
Gallatin Capital Management, LLC
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