Low Inflation Continues To Have Big Impact On Markets (TLT)

From Invesco: Over the past five months, the US has experienced a string of surprisingly low inflation reports. After peaking at 2.7% in February, annual growth in the Consumer Price Index (CPI) dropped to 1.7% by July.1 More importantly, “core” inflation, which removes the volatile food and energy components, fell from 2.2% to 1.7% over the same period.1

Because core inflation is an important determinant of bond prices and US Federal Reserve (Fed) policy, we believe it is important for investors to understand what drives it and how it is likely to evolve in the future.

There are two main drivers of core inflation

At Invesco Fixed Income (IFI), we divide the drivers of core inflation into two buckets.

  1. The first bucket is volatile core prices. These prices (mostly for goods, such as autos and apparel) tend to be driven by both global and domestic supply and demand, commodity prices and the US dollar. Prices of these goods fluctuate widely, but also tend to return to trend, or “mean revert,” fairly quickly.
  2. The second bucket is “sticky” core prices that are resistant to change. These are typically for services (such as housing and health care) that are driven mainly by domestic supply and demand. As such, these prices are generally more stable due to less influence from global price pressures. During the post-crisis recovery, sticky core prices have been supportive of overall rising US inflation.

What has curbed core inflation and what is IFI’s outlook?

Several of the initial downside surprises in core CPI were driven by drops in the sticky bucket (mostly services). Typically stable medical care, communication and housing inflation all slowed by unusual amounts. This is important because persistent declines in sticky core inflation could shift the US economy into a lower inflation regime, lowering our core CPI outlook. However, this bucket has since stabilized, indicating there is a good chance that overall inflation will mean revert toward historical levels in the medium term.

That being said, volatile core prices continue to fall, potentially holding back inflation. Recently, prices in the volatile basket have been falling almost as fast as they did in 2008 and 2009 after the global financial crisis.

Sticky core prices have rebounded while volatile core prices have slumped

Source: Federal Reserve Bank of Atlanta, data from Dec. 31, 2007, to July 31, 2017. Sticky bucket is Federal Reserve Bank of Atlanta Core Sticky Price Consumer Price Index. Volatile bucket is Federal Reserve Bank of Atlanta Core Flexible Price Consumer Price Index.

IFI believes that inflation could rebound in late 2017 or early 2018. This is partly because we believe sticky core inflation is set to trend higher. However, the outlook for the volatile bucket is more uncertain. Increased tech-driven efficiencies due to innovations like Airbnb, Uber, etc. have contributed to price weakness, an effect that could persist for some time. Yet we do not expect volatile core prices to continue falling as fast as they did in the post-crisis period, given the relative health of today’s economy.

Global growth should also be a catalyst for higher US volatile core prices: if the US dollar continues to weaken as other economies converge toward the US and commodity prices rise, prices in the volatile bucket could eventually move higher.

What does low inflation mean for the Fed?

The federal funds rate futures market has discounted the likelihood of another Fed rate hike in 2017. If volatile core prices stay low for the rest of the year, IFI believes the Fed will probably not hike rates in December, which has been our base case, and the next rate hike could be pushed back to March 2018.

Nevertheless, the Fed looks at inflation in many ways. Because monetary policy takes time to impact the economy, the Fed places particular weight on its inflation forecast. If the Fed believes future core inflation is likely to reach its 2% target, it may still raise rates even if actual core inflation remains soft.

What does this mean for markets?

Bond market prices currently imply a 30% chance that the Fed will hike interest rates in December.2 IFI believes this is too low and that US Treasury yields could be pressured higher in the next few months. We also believe our expectations for stable core inflation, coupled with a solid growth backdrop, are supportive of credit assets.

As we approach the September Federal Open Market Committee meeting, we see no major hurdles to the Fed launching its announced phase-out of asset reinvestments. We expect limited market impact from this phase-out given its well-telegraphed introduction.

Surprisingly low global inflation

Subdued inflation is not unique to the US. Inflation similarly peaked in the first quarter in most other developed economies, with little in the way of wage pressure. IFI believes this backdrop gives global central banks the flexibility to manage monetary policy in a gradual manner. IFI’s macro and credit analysis suggests that global bond markets would likely absorb gradual policy normalization. An unexpected increase in inflation, however, might cause global central banks to accelerate their pace of tightening. This more aggressive policy cycle does not appear to be priced into bond markets and may be disruptive to risky assets. We believe this makes bond markets vulnerable to an upside surprise in inflation that causes an acceleration of tightening. Although not our base case, we believe this risk is worth monitoring.

James Ong, Senior Macro Strategist; Noelle Corum, Portfolio Manager; and Ray Uy, Head of Macro Research and Currency Portfolio Management

1 Source: US Bureau of Labor Statistics, March 31, 2017, to July 31, 2017.

2 Source: Bloomberg L.P., Aug. 14, 2017.

Important information

The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The iShares Barclays 20+ Yr Treas.Bond ETF (NASDAQ:TLT) closed at $127.32 on Friday, up $0.49 (+0.39%). Year-to-date, TLT has gained 8.22%, versus a 10.42% rise in the benchmark S&P 500 index during the same period.

TLT currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #19 of 28 ETFs in the Government Bonds ETFs category.

This article is brought to you courtesy of Invesco and ETFDailyNews.com