Significant questions over the durability of the economic growth rebound remain, but fears over recession-induced deflation have quickly receded. US TIPS 5Y breakevens have reversed a large part of their collapse from early 2020 and, at 1.40%, have reverted to within 20bp of their 5-year average. Several factors have been at play:
There has been a rapid rebound in economic indicators that have dragged commodity prices higher, most notably oil. This has been a key factor driving the State Street Global Markets PriceStats® indicator back to signalling more normal levels of inflation (see Inflation in Focus: Normality in Sight).
The weaker USD is another factor, with a close to 4% decline in the DXY trade-weighted USD index since the end of June. This weakness is expected to persist given support for the USD from higher interest rates is no longer there. In addition, the greater toll that the pandemic seems to be exacting in the US and signs of deadlock in Congress do not favour a near-term USD rebound.
State Street flows and holdings data show that, to the end of Q2, positioning in US TIPS was heavily underweight (see the Q3 SPDR Bond Compass). As inflation expectations have rebounded, some of this underweight is sure to have been covered.
There are also longer-term concerns: the new record high in the gold price, often seen as a hedge against inflation, is one indication that market participants feel risks are increasing. While ageing demographics could continue to exert downward pressure on inflation, it is also true that the process of global trade liberalisation has been a key driver of the structural downtrend in inflation seen since the 1980s. With global political tensions rising and the liberal consensus that ‘more trade is better’ having fractured, this trend appears to be in reverse. Indeed, the next few years are likely to see more trade barriers, less immigration and more onshoring of production, all of which are likely to add to corporate cost pressures.
Real yields at new lows and still falling
The expansion in breakevens has been achieved despite some considerable downward pressure on nominal yields. Real yields have collapsed to all-time lows and, at -95bp for 10Y real yields, may not seem to offer much value. However, this is not necessarily that low by international standards, with 10Y Euro area real yields at -1.3% and the extreme of the UK at -3% (although this is distorted by the fact that UK linkers use RPI as its index, which is typically around 100bp above CPI, meaning a closer approximation is probably -2%).
Low real yields could also be the market’s verdict on the post-COVID-19 economy. It is certainly plausible that the growth-inflation trade-off could be negatively affected by the pandemic. Growth is likely to be weighed down by the productivity drag of 'zombie' companies, struggling with high levels of debt, while inflation could rise for the reasons already outlined.
Given the number of factors pushing inflation higher, it certainly looks unlikely that inflation expectations will collapse back to levels seen in March 2020. TIPS provide a degree of protection from a rebound in US inflation and should continue to benefit from Fed purchases. As noted above, they have already richened versus nominal Treasuries but what is noticeable is that, while spot breakevens have increased, the rise in the 5Y5Y forward inflation swap rate has been modest. It remains low versus its 10-year history and relative to indicators of price pressures such as the prices paid component of the National Association of Purchasing Managers (see chart below). So there is scope for the widening in breakevens to continue if fears rise that inflation will become more embedded.
Forward inflation breakevens still low on a historical basis