Bondholders’ Old Foe is Back

Market Blog Posted by lplresearch

Tuesday, March 30, 2021

Inflation is coming and, according to certain market-based inflation metrics, markets are expecting sustained inflation rates not seen since the late 2000s, although likely still at manageable levels. Inflation, which captures price increases in consumer goods and services, is a primary risk for fixed-income investors. For fixed-income investors, who receive fixed coupon and principal payments, the prospects of higher prices for goods and services threatens to erode the value of those fixed-income instruments. Generally speaking, when inflation fears increase, bond prices decrease and rates rise, which is what we’ve seen in the bond markets recently. In fact, the primary reason we’ve seen falling bond prices/higher interest rates since bottoming in March 2020 and again in August of last year, has been growing fear of inflation.

“With the amount of accommodative fiscal and monetary stimulus sloshing around the economy, we expect inflation rates to be above trend this year but then revert back to historical averages,” according to LPL Financial Chief Market Strategist Ryan Detrick.

How worried should fixed-income investors be about inflation? Very, if we are to believe what the markets are telling us. As seen in the LPL Chart of the Day, the five-year market-implied inflation rate, which is the grey shaded area of the chart, has risen sharply over the past few years, albeit from very low starting levels. These market-implied inflation rates, also called breakeven rates, are calculated by taking the difference between a nominal Treasury yield (blue line) and the yield on a Treasury Inflation-Protected Security of the same maturity (orange line). While an imperfect measure, breakeven rates provide the market’s best guess of what headline inflation rates will average over the course of future time periods. And the market is now pricing in inflation rates to average approximately 2.6% per year over the next five years, amongst the highest inflation expectations since the Great Recession in 2008-09, although still far from the levels seen in the 1970s and 1980s.

View enlarged chart.

To be sure, it is important to differentiate between the market’s expectations for inflation rates and realized inflation rates, which is the actual risk to fixed income investors. As can be seen from the chart, the market has predicted high inflation rates before—most notably in 2011 and 2013—and been wrong. Post the Great Recession, realized inflation rates rarely averaged over 2% in any one year much less over any five-year period. Will this time be different? Perhaps. There is a lot of fiscal and monetary stimulus, which could lift consumer spending, but structural factors such as globalization and technology, to name a few, have kept inflation rates well-contained historically. The wildcard though is how the Federal Reserve (Fed) reacts to higher prices. Historically, the Fed has tried to control rising prices by raising short-term interest rates before price increases got out of hand. Now, the Fed is saying they will wait longer to react. We’ll see if a slower Fed reaction function is able to offset those structural headwinds to sustained inflation rates. One thing is for sure though: Bondholders’ old foe is back—at least for now.


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