Time to get real on inflation-linked bonds

By Richard Turnill, BlackRock’s Global Chief Investment Strategist.

 Key Points

  • A slowing but growing U.S. economy, coupled with a Federal Reserve on hold, should boost the appeal of inflation-linked U.S. bonds.
  • China A-shares outperformed global stocks after the U.S. delayed its plan to further raise tariffs on Chinese goods.
  • We expect no policy change at this week’s European Central Bank (ECB) meeting. Policymakers’ read on the economy is set to be the main focus.

Time to get real on inflation-linked bonds

It may be time to add exposure to inflation-protected U.S. government bonds (TIPS). Why? The Fed has confirmed its intent to be patient with its next rate move and may let inflation temporarily breach its 2% target. Along with a slowing but growing economy, we believe this makes TIPS an attractive alternative to nominal bonds.

Chart of the week
Nominal and “real” yields of 10-year U.S. government bonds, 2010-2019

U.S. interest rate expectations have declined in recent months – as the Fed has put its monetary policy normalization on hold. We use 10-year U.S. government bond yields as a proxy for interest rates: Nominal yields and “real” yields (nominal minus inflation) have both fallen since late 2018, as the chart shows. We expect the Fed to hold off on any rate moves until at least the second half of 2019, after it pledged a more patient stance on policy. Combined with still solid economic growth, this is likely to further weigh on both nominal and real yields. The likely result: support for bond prices, as we describe in Bonds are back. Fed officials have also signaled they may be willing to allow for modest overshoots above the central bank’s inflation target to make up for past undershoots. This could lead inflation-protected bonds to outperform their nominal counterparts – underlining our call for adding some TIPS exposure to portfolios at the expense of nominal bonds.

The odds favor TIPS

We see TIPS performing well in our base case of a Fed pause and ongoing, albeit slower global growth. But what if this call is wrong? Take the scenario of an economy faring better than expected and the Fed raising rates sooner. Higher inflation expectations would likely be a critical driver of the Fed’s gear shift. This scenario could bode well for fixed income instruments indexed to inflation, such as TIPS. Markets are pricing in a big undershoot of inflation versus the Fed’s target – as has been the case for much of the post-crisis period. The Fed’s favored gauge – which measures the expected inflation rate over the five-year period that starts five years from today – points to inflation of just above 1.8%. The recent change in the Fed’s commentary around inflation suggests the central bank would likely want to see inflation slightly exceed its target before considering a resumption of policy tightening – for fear of choking off economic growth.

We also find opportunities in inflation-linked bonds in the eurozone. We expect the region’s inflation to remain well below the target set out by the ECB. Yet we see the current pricing of the macroeconomic outlook in inflation-linked product markets as overly pessimistic, particularly in comparison with recent rebounds in riskier European assets. We view inflation-linked debt as expensive in the UK. Fears about a no-deal Brexit and its potential hit to the British pound have driven up inflation expectations – even though we see the likelihood of such an outcome as low.

What is the case against inflation-protected securities within a fixed income portfolio? The risk would be a renewed spike in U.S. recession fears – and growing market expectations that the Fed may cut rates. TIPS would likely underperform nominal bonds in such a scenario, although we would still anticipate positive absolute returns. We see this scenario as unlikely in 2019, however, given the strength of the U.S. economy. Bottom line: We see potential for TIPS to play a valuable role in portfolios in the near term.

Week in Review

  • China A-shares scored their biggest weekly gain since mid-2015 after the U.S. announced it would hold back on a planned tariff increase on Chinese goods. Better-than-expected factory activity data and MSCI’s confirmation on raising index weighting of Chinese domestic shares also helped. Global stocks steadied. A summit between U.S. President Donald Trump and North Korean leader Kim Jong Un ended without any agreement. Ten-year U.S. government bond yields hit a one-month high.
  • The British pound rallied on diminished perceived risks of a no-deal Brexit. UK Prime Minister Theresa May promised lawmakers a chance to vote on a no-deal Brexit and on asking the European Union to delay the deadline, if her revised Brexit deal is voted down.
  • U.S. gross domestic product (GDP) grew faster than expected in the last quarter of 2018, underlining the strength in the economy. China’s factory activity contracted in February, but there were signs of improving domestic manufacturing demand.

Global Snapshot

Week Ahead

Date: Event
March 5 Eurozone retail sales; U.S. non-manufacturing ISM Report on Business
March 7 ECB monetary policy meeting
March 8 U.S. employment situation
March 9 China Consumer Price Index (CPI) and Producer Price Index (PPI)

We expect no policy change at this week’s ECB meeting. But any further signs of policymakers acknowledging a weakening growth outlook would be notable, following the recent shift in tone from some of the traditionally hawkish Governing Council members. The ECB staff will also release updated macroeconomic forecasts which could see downgrades of both growth and core inflation projections. We expect the ECB to keep rates on hold at least through 2019, and see a high likelihood it will renew a key liquidity provision program later in the year.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon