Fade the fall in inflation expectations

admin | December 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The most surprising shift in fixed income markets this fall—more surprising than the flattening yield curve or wider spreads—has been the sharp drop in implied inflation. The rate implied by the yield spread between 10-year Treasury notes and TIPS has dropped 35 bp since September and now hovers just above 1.8%. Either the Fed has lost some credibility or the market expects recession. Neither seems likely. Longer rates consequently seem biased higher.

Exhibit 1: A 35 bp drop in implied 10-year inflation since September

Source: Bloomberg, APS calculations

Of the leading possible explanations for a drop in 10-year implied inflation, the Fed’s commitment to a 2% target seems the least plausible. Fed inflation targeting is now as explicit as it has ever been, and the Fed’s tools for getting inflation to target more extensive than ever. The Fed has gone from implicit targeting in the 2000s to explicit targeting of 2% in this decade. Statements from FOMC governors and papers from Fed staff are full of discussions of the means for hitting that target. Former Chairman Bernanke has written extensively about letting inflation run above 2% for extended periods so the Fed can deliver 2% even after periods below that mark. And Quantitative Easing, once the purview of academic papers, is now tested. It’s hard to doubt the commitment.

It might be possible to doubt ability since the Fed struggled to get inflation to target for long stretches since the 2008 financial crisis. That increasingly looks like special circumstances. The flow of new and returning workers into the labor force certainly seemed to hold down wage inflation as they replaced older workers that earned more money. The recently named president of the San Francisco Fed has commented on this here. In a service economy, wage inflation matters. That vulnerability for monetary policy should fade over long horizons.

As for a sustained recession that might force the Fed to fight low inflation again while close to the zero lower bound in interest rates, that seems like a low probability. Economic growth does look likely to slow from the pace of 2018 as the impact of discretionary government spending fades. But moderating growth does not mean recession.

Since wider spreads in risk assets has done some of the Fed’s work, look for the December 19 FOMC to show a lower path for the policy dots. Inflation expectations should bounce higher, and long rates along with them.

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The view in financing

Secured lending or repo rates continue to face upward pressure from a heavy flow of new Treasury debt that needs financing and bloated primary dealer balance sheets and investor positions that need financing, too.  Essentially, year end pressure is being exacerbated from this financing demand.  The turn—funding from December 31 to January 2—trades at 3.00% for MBS collateral and 2.97% for Treasury collateral.  Short periods over year end are priced with the same pressure with MBS funding Class A (December to January) at 2.68%. The pressure persists despite the cash from slightly less than $100 billion of Treasury bills maturing over the next five weeks. After the turn, funding markets likely will focus on a rate regime bearing the markets of a December 19 Fed hike of 25 bp and a bump up in IOER of 20 bp.

The view in rates

The Fed’s dots offered a simple guide to the likely path of shorter rates for most of the year, but the tightening of financial conditions since September has started doing some of the Fed’s work. The Fed dots should change on December 19. That leaves fair value in 10-year rates around 3.0%. From current levels around 2.90%, look for rates to bounce higher.

The view in spreads

Credit spreads should continue widening until they have priced fully for decelerating growth next. Slower growth poses risk to the nearly $3 trillion in ‘BBB’ credit, especially the most highly leveraged names. Names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Wider spreads in corporate credit should put pressure on other spread assets, although consumer debt should show less volatility. Agency MBS, which also will need to adjust to likely falling bank appetite, should widen, too.

The view in credit

Although corporate balance sheets have to deal with higher leverage, household balance sheets looks strong. The weakest pockets on the household balance sheet look like subprime auto credit and student loan debt.