Patience lifts expectations for inflation but not growth
admin | February 8, 2019
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 Fed may be waiting patiently for growth and inflation to point the way for monetary policy, but the market is already guessing about the result. Implied growth has weakened since the start of the year, but implied inflation has taken a jump in the direction of the Fed’s target. Since monetary policy traditionally assumes central banks really can only control inflation—the rest depending on other forces in play—the Fed may consider the results of its patient approach a victory so far. That may give the Fed even greater confidence in its approach.
Since early January the expected real rate of interest over the next 10 years implied by the TIPS market has edged down from 1.0% to 0.80% (Exhibit 1). Real rates usually price somewhere below expected real growth—the providers of equity capital to the economy have to earn something, too—so expected real growth has fallen. Inflation as implied by the spread between 10-year Treasury notes and TIPS has jumped, meanwhile, from a low of 168 bp to a recent 183 bp. It is still shy of the Fed’s 2.0% target, but it has moved in the right direction.
Exhibit 1: Since January, implied growth is down and inflation is up
Source: Bloomberg, Amherst Pierpont Securities
The Fed should consider the market results so far as a win for its patient approach. Monetary policy, including target rates, balance sheet policy and forward guidance, should have primary if not exclusive influence over inflation. Some of that influence obviously comes from rates and balance sheet. But a significant part comes from forward guidance and its influence on inflation expectations. That has really been the monetary policy revolution since the early 2000s. Inflation expectations lead the way. And the Fed has clearly done something to get the market back toward 2.0%.
Expected real growth, on the other hand, has slipped. That may be more about the other forces at play in the economy. The simplest model of economic growth considers the joint impact of labor force growth and productivity growth. As my colleague, Stephen Stanley, points out this week, the labor force has shown more promise of growing lately, but trend productivity remains stubbornly low. The market does not seem optimistic.
The result may explain why the market so far seems to lean toward the next Fed move being a cut rather than a hike. The Fed still needs to nudge inflation expectations a little higher, and growth may require a little boost. For investors, this still implies a little more credit risk than volatility risk. But it’s only relative. The general contribution of a patient Fed is likely a limited range for rates in 2019 and an increasing role for carry in fixed income portfolios.
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The view in rates
Even though the slope of the yield curve between 2- and 10-year notes has remained relatively stable since the beginning of the year, it still looks tactically likely to steepen more led by higher 10-year rates. Fair value on 10-year notes still looks closer to 3.0%. The Congressional Budget Office projects labor force growth of 50 bp a year for the foreseeable future, and the San Fran Fed (here) projects productivity growth of 1.28%. The combination, with some premium for inflation, pegs fair value around 3.0%. Rates should drift up in that direction and steepen the curve.
The view in spreads
More investors anecdotally have started shopping for carry. A stable Fed should keep encouraging carry trades and that should help performance of both corporate debt and MBS. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt. Agency MBS should also tighten but underperform corporates for at least the next few months.
The view in credit fundamentals
Corporate credit fundamentals remain vulnerable, but only if slower economic growth creates problems. The Fed has signaled that it stands ready to buffer any material softening. Management may need to trim equity buybacks and reduce debt. Households, however, look strong. Unemployment should fall through 2019 even as growth slows. Strong net worth and manageable debt service should help households, too.
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