Blue Haven

Inflation fears pressure bond prices

By March 15, 2021 No Comments

As the pandemic’s grip on our economy eases in the coming months, most economists expect a rapid expansion in our economic output in 2021. The consensus estimate calls for a 10% expansion of GDP in the US in the first quarter. Estimates for 2021’s economic growth range from 5-7% GDP in the U.S. and 5-6% GDP growth in Europe. There is massive amount of pent up demand for services like travel and leisure, and this will in turn boost industries such as apparel, hotels, autos, restaurants, and other “brick & mortar” businesses across the country. While it will be great to see the economy running at full capacity again, we must be mindful of the secondary effects of what a white-hot economy could bring along for the ride.

Inflation fears

Lingering in the background are fears that inflation – the overall rise in the price of goods & services – could rise above the 1.8-2.2% range of the past few years, potentially much higher. Inflation is like salt in a stew; a little bit is delicious, but too much and you can ruin the dish. Both stocks and bonds have been loving the very modest (by historical standards) inflation rates of the past few years. This persistently low inflation has been one of the most important catalysts driving stock prices higher. Low inflation has also powered the biggest bull market in bonds ever recorded.

Stock valuations tend to rise above historical norms whenever interest rates are low, as the chart below illustrates. This chart shows the cyclically-adjusted-price-to-earnings ratio, or CAPE ratio. Created by Nobel Laureate, Robert Shiller, the CAPE ratio helps smooth out the effects of boom and bust cycles on corporate earnings. The CAPE ratio is a respected measure of stock valuations, and here we can see the inverse relationship between stock prices and prevailing interest rates (in blue). When interest rates have been low, stock valuations have trended higher, and when interest rates begin to rise, stocks have been weaker.

The Fed’s Role

The Federal Reserve has a mandate to keep inflation in check, and ever since short-term lending rates were cut to 0%, market watchers have been looking around for signs of percolating inflation. We are starting to see some of those signs now. Prices for oil, copper and lumber, are trading anywhere from 1-year highs to the highest they’ve ever been. The same goes for “soft” commodities like wheat, corn, coffee, and soybeans.

Inflation is the most innocent of concepts – more money chasing limited goods creates higher prices for those goods. Companies that purchase a lot of these raw materials need to pass on higher prices to consumers, or else their profit margins decline. This is why in a phase when inflation is rising, the economy needs to be running good and hot, lest we repeat the nasty stagflation environment of the early 1980’s.

Both the Treasury market and the stock market like to front-run the news. If inflation is around the corner, both markets will want to reflect that future now, to “price it in”. We’re already seeing Treasuries anticipating higher inflation, as yields have risen steadily over the past month. Once we find ourselves in a “zero-interest rate” environment, as we did in 2020, the path of least resistance for interest rates is usually higher. However, bear in mind, the velocity of the move usually has a greater effect on markets than the end-result of the move.

Bonds will underperform in an inflationary cycle

It’s important to remember that as yields rise – whether due to inflation, or because of optimism on economic growth – bond prices will fall. And if inflation expectations rise quickly, as they’ve done so far to start the year, bond prices will fall quickly too. For long-term investors, short-term drops in price of a bond fund are fine, and to be expected. The income you receive from your investment remains the same, and the ETF will sport a higher yield.

Bond funds have been in the biggest bull market any of us have seen in our lifetimes, so it’s reasonable to expect less capital appreciation in these funds going forward. The key attributes of bond exposure are for diversification and income stability – and both of these attributes remain in place, even if the bond market is a little on edge over inflation right now.

We are watching economic indicators like the Consumer Price Index (CPI) and the Producer Price Index (PPI) to get advance notice of pending inflation. These are metrics that the Federal Reserve is studying, and so we study them as well. The last PPI print from January showed a sizable increase vs expectations, with produce prices rising 1.3% for the month vs a consensus estimate of just 0.4%.

Impact on our portfolios

Even though the Federal Reserve hasn’t raised the fed funds rate, that hasn’t stopped market interest rates from moving higher on their own. This is being driven by expectations of strong economic growth, fueled by the re-opening of the economy, which is expected to trigger higher inflation than we’ve seen in years past. As a result, many reliably steady bond ETFs we invest in, have been more volatile than usual to start the year. AGG, for instance, is down 3.20% year-to-date. That would register as the largest yearly decline for the AGG in the last 40 years.

As far as our fixed income allocations are concerned, we haven’t made any major adjustments. But, in the current interest-rate environment, floating-rate bond funds like VRP and BGT have been performing well. In addition, high yield ETFs like SHYG, USHY, and HYG, which tend to be more economically sensitive than interest-rate sensitive, have remained steady. In taxable accounts, we’ve used the drop in bond prices to execute some tax-loss harvesting trades, which we can use against some of our gains in equities.

In summary, the market is expecting economic growth to pick up steam as the economy reopens and the vaccination roll out continues. These expectations are ushering in higher interest rates as the market forecasts increased inflation in the intermediate term. These are negative catalysts for bond prices and is the main reason bonds are off to their weakest start in years. With that said, we still expect bonds to act as a diversifier against stock market declines and produce reliable income streams for our clients.



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