Jan 20, 2017 | Post by: Roman Chuyan, CFA Comments Off on Inflation Is Now 2%, Negative For Bonds

Inflation Is Now 2%, Negative For Bonds

Summary

  • December CPI inflation rose to 2.07%.
  • A number of reasons to expect interest rates to continue to rise in the near term, but perhaps more gradually than last year’s jump.
  • I have reiterated our recommendations for active fixed-income investors.

Global interest rates began to rebound since reaching all-time lows in July, and the rise accelerated in November-December, after the presidential election. Inflation has been, and continues to be, the primary driver. CPI inflation rate ended the year 2016 at 1.7%, and the 10-year Treasury yield at 2.45%.

Bond prices, which are inverse to yields, fell in 2H-2016, and most longer-term and aggregate bonds (AGG, BND +2.4%) ended the year with a low-positive return.

Inflation is now above 2%

As I wrote since mid-year here and here, I expected inflation to continue to rise after rebounding from zero in 2015. It did so in the second half of 2016. By the end of the year, economists finally stopped talking about deflation. In my Oct. 30th article, when inflation was at 1.46%, I wrote “inflation will likely rise from here – it’s only a matter of time before total inflation rises to core inflation (2.2%).” My reasoning was based on the “base effect” in commodity prices, and on the fact that total inflation tends to oscillate around more stable core inflation which excludes food and energy prices.

DoL numbers reported this week showed that total CPI inflation jumped to 2.07% in December (see chart) and producer prices jumped to 1.55%. So, we’re back to a more “normal” situation of total CPI inflation around core. The base effect will still be strongly positive in the next 1-2 months, which means that it will likely move above core.

Inflation - tactical investment managementInflation now moving above 2% is kind of a big deal, because the Fed’s target is 2% (though the Fed looks at Core PCE, which lags but will likely catch up as well). That’s why the Fed officials including Chair Yellen recently commented that the economy is “close” to its goals. The Fed expects to hike rates three times this year – this remains to be seen, but one is very likely coming up in March.

2% inflation level is also important to Treasury yields and bond prices.

Treasury Yield and Inflation

The Treasury note yield typically compensates for the loss of consumer purchasing power, plus a premium. The historical average premium has been 2.4% since 1960, but it varied widely (see chart). Recently, in 2011 and in 2016, the yield fell below inflation, mainly due to the Fed keeping rates low, and to total inflation staying low. However, the Fed is no longer buying bonds, and in fact, raising rates. In addition, expectations of higher growth and inflation all point to substantial yield premium required over core inflation.

Our year-end six-month outlook calls for CPI inflation to rise to 2.1% (we are basically already there at 2.07%), and for 10y Treasury yield to 2.8%. This assumes yield premium of 0.7%, slightly lower than 0.75% on Dec. 31, 2016, and perhaps a conservative assumption.

More recently, after peaking at 2.6% in December, the 10y yield retreated to around 2.3%, but began to rise again to 2.4% on Wednesday when the jump in inflation was reported – in retrospect, an excellent chance to sell long-term bonds. It now trades around 2.45% – still a good chance to sell, in my view.

What It Means To Bond Investors

2-5-10 Y Treasury Yields - tactical investment

The above chart shows that the yield curve slope, or spread between the 10y and 2y yields, is now very tight around 1.2%, and may widen going forward, which is another reason to expect long rates to rise. It also illustrates that yields are always volatile. My expectation is for a move to 2.8% on the 10y, but unlike the Nov.-Dec. jump, I expect it be slow and volatile.

We continue to recommend maintaining short portfolio duration to minimize exposure to rising rates. Our recommendations to active fixed income investors (that is, those not satisfied with buy-and-hold approach) in December to shift from FRNs to 2-3y corporate bonds, stands at this time.

For the remaining 40% we continues to recommend leveraged loans. These senior secured HY loans are floating rate (minimal interest rate exposure), and are issued by lower-rated (BB or lower) companies, which means that they earn high-yield type spread. The rise in LIBOR rate in 2H-2016 also boosted coupons.

If you are a regular reader of MCM’s Tactical Strategies reports, you had an advantage of our timely bond recommendation last year. Learn more about our fundamentals-based, forward-looking approach to tactical investment management. If you are an advisor and are interested in adding a tactical component to your practice, please contact us to begin receiving the report.


Disclosure: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Advisor. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.

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