A look at inflation rates implied by TIPS yields across the maturity spectrum shows financial markets believe low inflation is here to stay. According to TIPS pricing, annualized inflation rates will average less than 2% over the next 30 years, a still pessimistic expectation [Figure 3].
THE OIL WILD CARD
The recent improvement in oil prices has helped TIPS by boosting CPI inflation expectations, but a renewed decline could erode the potential value in TIPS. If oil prices fall again, overall CPI may decline again and weigh on TIPS prices. Conventional Treasuries may fare better under such a scenario. However, mere stabilization in oil prices means that the year-over-year decline in energy prices would diminish, along with its downward pressure on inflation. Additionally, U.S. dollar strength has reversed in recent weeks and, in our view, may moderate in 2016, alleviating another downward force on overall inflation. Finally, the University of Michigan 5- to 10-year consumer inflation rate expectation rose to 2.7% in March, more than expected and matching a 6-month high.
TURNING THE CORNER
Consumer inflation expectations, like TIPS-implied inflation expectations, remain low in a historical context, but are among the few factors suggesting inflation may be turning the corner. The Fed has already stated it may be willing to let inflation run higher than its 2% target; however, if the recent increase is sustained (and not temporary as expected), or recedes only slightly, TIPS may benefit from higher inflation compensation.
TIPS may be a more compelling option than regular Treasuries or other high-quality bonds in such an environment due to their inflation protection. And if the period of stagflation turned into a recession, the conventional Treasury aspect of TIPS may help them outperform areas of the market with more credit risk, such as investment-grade bonds, high-yield, and emerging markets debt.
CONCLUSION
With inflation on the rise, economic growth below trend, and the Fed taking a more gradual approach, bond prices may experience a push and pull, leaving them range bound. Although we do not expect TIPS to maintain the pace of recent performance, inflation compensation may provide an edge in what is expected to be a challenging return environment for bonds over the remainder of 2016. The implied rate of inflation suggested by TIPS yields remains very low, making TIPS attractive relative to Treasuries and an option to consider for suitable investors seeking a high-quality bond anchor in their portfolios.
Anthony Valeri is investment strategist for LPL Financial.