Municipal Market Commentary – December 10, 2014
What Happened to Inflation?
For anyone paying attention to the news pundits and armchair economists over the past few years, one theme was very clear; Inflation is coming. As with all things based on economic predictions, this prediction of rising inflation will, probably, eventually come true. The reasoning for these predictions of dramatically rising prices was pretty clear, the Fed’s economic stimulus activity, specifically Quantitative Easing, was pumping so much money into the economy that inflation was the only logical result.
For bond and fixed income investors these predictions of looming inflation had the potential for specific and dire consequences. If an investor currently owns fixed income investments that provide regular interest payments, even when those payments arrive on schedule, the effect of inflation will reduce the buying power of each of those interest checks. For investors planning on purchasing bonds, inflation may push the price down on bonds in the marketplace causing tomorrow’s price to be lower than the cost if purchased today.
But a funny thing happened on the way to higher consumer prices and lower bond values. Even with the Fed’s ongoing and aggressive monetary policy, inflation never really kicked in. For experienced bond investors and those that have been listening to our advice to avoid any attempts to time the market, this reality turned out pretty well because if inflation is a negative for bond investors, the lack of inflation means bond values, and prices keep going up. This still leaves two questions to be answered: 1) Why didn’t the Fed’s activity cause the predicted inflation? 2) What will happen next?
For the answer to the first question, using the 20/20 vision of hindsight, it is easy to see that weaker than expected economic growth, ongoing investor demand for high quality fixed income investments and the low level of international interest rates have kept inflation and interest rates at low levels when measured against historical norms.
As far as our second question, while we hesitate to join those that make a practice of making predictions of future market moves, we can look at certain market fundamentals and see a logical, potential path forward. One thing we do know is that the bond market generally trades on future expectations. These investor expectations are influenced by multiple factors including, but not limited to, Fed activity, economic growth patterns and inflation projections. One market based projection of future interest rate expectations can be seen by examining the recent trading in Treasury Inflation Protected Securities (TIPS).
Currently this trading pattern shows a trend for lower inflation expectations over the past 12 months (See our Trader’s Analysis below). This trend toward lower inflation expectations may suggest to the Fed that they should not be so quick to increase the Fed Funds target rate and rather assume the risk of an overheated economy and the real inflation that might result.
This trend toward lower inflation expectations may suggest to the Fed that they should not be so quick to increase the Fed Funds target rate.
Investing in bonds involves risk including the possible loss of principal. Income may be subject to state, local or federal alternative minimum tax. When interest rates rise, prices will fall, when interest rates fall prices will rise.
Our Trader’s Analysis charts the Fed’s five-year forward breakeven inflation rate.
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