Investors Scale Back Inflation Bets

A widely tracked measure of inflation expectations is mired below 2% even in a tight U.S. job market

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Bets on a pickup in inflation are falling out of favor, underscoring investors’ skepticism that the U.S. economy will be able to stage a rebound after a soft start to the year.

The growth outlook has dimmed over the past year as measures of manufacturing activity, consumer spending and business confidence have waned. The cool-down in the economy helped keep inflation from running past the Federal Reserve’s 2% target for a seventh straight year in 2018.

The fact that inflation has continued to undershoot targets has allowed the Fed to suggest it will pause its rate-increase campaign, helping the S&P 500 rise 12% in 2019 and notch its best two-month start to the year in decades. But many bond investors have taken a more pessimistic view, questioning whether muted price increases are another sign that prospects for the economy and earnings are dimming.

Investors will get another look at where inflation is headed on Friday, when the Labor Department publishes its monthly jobs report. “I’m in the camp of those who are doubtful,” said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management.

Mr. Ren said he bought Treasury inflation-protected securities in 2017 but wound down purchases last year and believes he won’t buy much, if any, this year. TIPS offer yields—albeit relatively small ones—that rise together with inflation, making them most desirable to investors when they believe prices across the economy are heading higher.

“I thought 2017 would be a good year because that’s the year we all talked about synchronized global growth,” Mr. Ren said. “But we didn’t see [inflation], and now, all the data shows a slowdown.”

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A widely tracked measure of investors’ expectations for average annual inflation over the next decade, known as the 10-year break-even rate, has remained below the Fed’s 2% target in 2019. Measured by the gap between yields on the 10-year Treasury note and 10-year TIPS, the break-even rate was at 1.95% on Thursday. That is up from recent lows in December but still below the four-year high of 2.18% hit in May, according to FactSet.

Demand for other products that hedge portfolios against inflation has also waned in recent months. The Schwab U.S. TIPS exchange-traded fund is on track to post a quarterly outflow for the first time since 2013, according to Lipper. And surveys show investors are growing increasingly doubtful that the economy will heat up. Among global fund managers surveyed by Bank of America in February, 55% expected below-trend growth and inflation over the next year, the highest share since December 2016.

Few—including Mr. Ren—believe that the U.S. is on the brink of recession. The unemployment rate remains near multidecade lows. For 100 consecutive months, the labor market has added more jobs than it has lost. Wages have risen at least 3% on a year-over-year basis for six straight months, and data Thursday showed gross domestic product rose more than expected in the final quarter of 2018. In the past, these factors—especially low unemployment—would have prompted investors to fret about inflation.

Yet a tight labor market hasn’t been enough to keep inflation running consistently at the Fed’s 2% target. That has stirred debate among economists about whether factors like the diminishing power of unions and globalization have created an environment in which inflation is likely to stay muted. One factor that could change the picture: the Fed.

In recent months, Fed officials have begun publicly discussing potential changes to how they define their inflation target. One approach would have the Fed aim for an average of 2% inflation over several years, meaning it would deliberately seek modest overshoots of the 2% target during good times to make up for falling below target during recessions. Officials have said they won’t make any changes before early next year.

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“These are incredibly dovish concepts, a complete change in the response function of the Fed,” said Matt Toms, chief investment officer of fixed income at Voya Investment Management. “It’s suggesting the Fed won’t immediately respond to kill inflation.”

Traders have begun pricing in a small chance of the Fed lowering short-term interest rates this year, a move that could help nudge inflation higher by lowering the cost for businesses and households to borrow and invest. Federal-funds futures, which track market-based expectations for monetary policy, showed Wednesday a 20% chance of the Fed lowering rates by year-end, according to CME Group. That compares with around 4.1% at the start of the year.

So far, though, there are few signs of investors positioning for an uptick in growth and a corresponding boost to inflation. The 10-year Treasury yield, used as a reference rate for everything from mortgages to auto loans, has drifted along in a relatively narrow range this year after reaching multiyear highs above 3% in 2018. The 10-year yield tends to rise when investors are confident about growth and retreat when they are less sure about the economic outlook. Yields rise as bond prices fall.

Mutual funds and exchange-traded funds tracking equities have also logged steep outflows, while those offering investors exposure to bonds are posting net inflows so far in 2019, according to a Bank of America analysis of EPFR Global data.

That pattern suggests that investors aren’t convinced that the economy is about to heat up. Inflation tends to make Treasurys less attractive to investors, since it chips away at the purchasing power of their fixed payouts. “The Fed can do everything they try to do to increase inflation expectations, but the market is doubtful they can achieve that,” Mr. Ren said.

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7 thoughts on “Investors Scale Back Inflation Bets

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