May 4, 2020 / 5:07 PM / a month ago

U.S. inflation-linked bonds may underprice risk of higher inflation

(Reuters) - U.S. inflation-linked bonds are reflecting expectations that rising inflation is not going to be a problem for the foreseeable future, but some analysts recommend buying these instruments in case price pressures pick up, or at least be not as negative as the market is anticipating.

Business shutdowns designed to stem the spread of the COVID-19 illness caused by the new coronavirus have slammed economic growth. Unemployment is soaring, prices are falling and some fear that the worse-case scenario could involve deflation, where prices fall and consumers delay buying goods.

Expectations based off the breakeven rates on Treasury Inflation-Protected Securities (TIPS) are dire. The bonds are pricing in deflation for the next two years. Over the longer term 10-year TIPS breakevens USBEI10Y=RR show average annual inflation at only 1.06% for the coming decade.

“Even in a stressed scenario for inflation over the next couple of years ... relative to the inflationary path that’s priced in, we don’t think it will be that bad,” said Tiffany Wilding, North American economist at Pacific Investment Management Co. “It’s very cheap to get longer-term inflation insurance through this market.”

Unprecedented monetary and fiscal stimulus from the U.S. Federal Reserve and government should blunt some of the weakness caused by the virus shutdowns, though the economy is unlikely to be able to escape at least a short, sharp drop in growth.

The Fed has also been buying bonds, including TIPS, to help stabilize conditions in the Treasury market, which suffered from extreme illiquidity as the virus spread globally in March.

Over time, some say continued fiscal spending and ultra-supportive monetary policy could push inflation higher as the economy returns to more normal conditions.

“The policy response is unlikely to be unwound very quickly,” said James McCormick, global head of desk strategy at NatWest Markets in London.

It also comes as longer-term trends are turning, with a shift away from globalization and open borders that have defined the past three decades. These may be already planting the seeds of future price increases.

“The foundation for a change was already falling into place in recent years, and I think the coronavirus and the size of the policy response and the acceleration of the trend in deglobalization and populism is probably going to test this really strong hypothesis that there is just no inflation,” McCormick said.

Federal Reserve quantitative easing after the financial crisis of 2007-2009 led to expectations that inflation would pick up as money from the bond purchases made their way through the economy.

That did not happen, however, with growth remaining below trend and inflation subdued as the policy failed to translate into an increase in demand or higher wages. Core PCE is below the Fed’s 2% target and slipped to an annual rate of 1.7%, from 1.8%, in March.

As long as inflation is subdued, the Fed is likely to keep its policies loose and could add additional lending programs or even yield caps in an attempt to stimulate growth and higher price pressures.

The Fed has also indicated that it may let inflation run above its target before acting to tighten conditions.

“I think we lean towards worrying about deflation more than inflation at this point and you can see in the action of central banks,” said Jonas Goltermann, senior market economist at Capital Economics in London.

Inflation lags growth and may not pick up until closer to 2022, even if growth rebounds in the second half of this year, said Pimco’s Wilding.

The longer-term inflation picture may depend on whether fiscal stimulus continues even as the economy returns to normal. In each scenario, however, inflation is unlikely to be as low as is currently indicated by the market, she said.

NatWest’s McCormick sees the low inflation expectations that are priced into TIPS as a good time to buy the bonds on a longer-term investment horizon.

“It’s a bit more of a long-term bet, but if you buy into my views, which is a short-term demand shock followed by inflation risk, then you’d definitely want to be accumulating breakeven inflation type of plays heading into the next year,” he said.

Reporting by Karen Brettell; editing by Jonathan Oatis

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