U.S. Treasury bonds are considered to be free of default risk because investors believe there is no chance the U.S. government will default on interest and principal payments. Because of that, nearly all other segments of the bond market are priced as a yield spread to treasuries.
If U.S. Treasuries are in fact free of default risk, then inflation expectations are the primary factor determining the required yield for investors to price the future stream of cash payments from these bonds. The higher the future expectations of inflation, the higher the yields investors will demand to compensate for inflation risk.
Since interest rates are a critical component of pricing bonds and nearly all other financial assets, then one can see the extreme importance of inflation expectations in pricing financial assets.
The Federal Reserve Bank uses explicit inflation targeting to announce publicly that it seeks a 2 percent medium-term inflation rate for the economy. Inflation used to be monitored by measuring the Consumer Price Index (CPI), but as flaws in this metric were made apparent, the Federal Reserve Bank chose to focus on Personal Consumption Expenditure (PCE) inflation.
The Department of Commerce produces the PCE Index largely because it considers a wider range of household spending. Officially, the Trimmed Mean PCE Inflation Rate for October 2017 was 1.6 percent slightly below the Fed’s target.
The 10-Year Breakeven Inflation Rate is a market-based measure of inflation expectations that is calculated as the difference between the yield on ten-year constant maturity Treasury bonds and ten-year Treasury Inflation Protected bonds. The market implied inflation rate as of December 15, 2017 is 1.88 percent.
As a complement to other core inflation measures, the Federal Reserve Bank of New York constructed the Underlying Inflation Gauge (UIG). The full 346 series data set measure of UIG includes the CPI components, as well as a wide range of nominal, real and financial variables.
The UIG, although not as well known, has outperformed other measures for forecast accuracy and provides more timely signals of turning points in inflation. The analysis is run on a daily basis at the New York Fed, but estimates are only publicly available monthly. The UIG estimated for November 2017 was 2.95 percent.
Interestingly, as the rhetoric from the Fed has claimed, “we don’t see inflation” and several common measures are below the 2 percent targeted rate, the UIG is already well above the target rate. If the UIG, as intended, is a broader and more comprehensive measure, then the Fed is already “behind the curve” in raising interest rates.
In 2018, the Fed may have to play catch up by raising rates more than the market anticipates in order to contain inflation. Unanticipated interest rate hikes may wreak havoc on the Treasury bond market because, as rates rise, bond prices fall.
Since the rest of the bond market is priced off of U.S. Treasuries, and nearly all financial assets are impacted by interest rates, the outlook for financial markets globally diminishes as inflation unexpectedly increases. Nearly a decade of zero interest rates combined with numerous rounds of quantitative easing may have saved the economy from the financial crisis, but going forward, the unintended consequences of growing inflation may have a dire outcome.
Aash M. Shah, CFA is a senior portfolio manager at Summit Global Investments, an SEC registered investment adviser specializing in low volatility investment strategies. Learn more at www.summitglobalinvestments.com.
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