Shifting views on inflation, central banks pushing rates higher

Henry Peabody,  Diversified Fixed Income Portfolio Manager/Team Leader

Boston  - Investors in the lower-for-longer camp might see the latest move higher in interest rates as just another head fake. However, rising inflation expectations and an important shift in central bank policy could provide the momentum to push rates higher than many expect.

In the U.S., yields on the 10-year Treasury note have risen about 50 basis points from the all-time low in early July, to above 1.8%. Meanwhile, the 10-year inflation breakeven rate has climbed to its highest level in over a year, although it's still below the Federal Reserve's 2% target rate, which also happens to be the long-term average.

This suggests that inflation expectations remain fairly well anchored, something the Fed and other central banks strongly want to reverse. Hence, Fed Chair Janet Yellen's comment around running the economy a bit "hot." In spite of this, the current consensus is that the Fed will raise rates at the December meeting. Therefore, the more important question is the pace of hikes in 2017.

For many years, investors have had a lower-for-longer mindset regarding interest rates and central banks. Central bankers have argued in favor of quantitative easing (QE), and until recently extended that argument to support additional policy easing - a "more is better" strategy.

Yet, we reached a point, first recognized by the markets and then the Bank of Japan (BOJ), at which low yields and flat curves damaged the flow of credit through the banking, pension and insurance systems. Everyone chasing the same assets led to spiraling bond prices and impaired business models, hampering capital allocation to the real economy. There was a lower bound.

In response to this, the BOJ is engineering a steeper curve with a pegged 10-year rate - arguably a step toward monetizing fiscal policy. Boston Fed President Eric Rosengren also commented that the Fed could alter its portfolio to steepen the curve to restrain commercial real estate, and the European Central Bank (ECB) will likely follow when it adjusts its basket of eligible securities to purchase. This is an excellent example of policy coordination.

In response to inflation expectations perking up in the context of a policy shift - a very positive combination - government bond yields have moved higher. A rise in rates and falling bond prices would punish investors in what are viewed as safe U.S. Treasurys. In this case, we believe safety isn't always safe. Investors have grown too comfortable with central bank backing, which could result in volatility and a painful adjustment.

Many managers and investors look to Treasury Inflation Protected Securities (TIPS) for inflation protection. This sector is on track for its highest annual inflows since 2011 and has seen inflows in nine of the last 10 weeks, The Wall Street Journal reported. However, TIPS offer relative return, not total return. TIPS also have some characteristics of U.S. Treasury bonds and represent long duration at low yields. For this reason, we prefer to express a view on inflation through positive corporate fundamentals, commodity related credit, and non-dollar debt with higher yield in countries that benefit from increased trade and structural reform.

Finally, holding cash is another strategy in a fixed-income landscape where we don't see adequate compensation for taking on rate and credit risk. Cash represents a very inexpensive call option.

Bottom line:  Lower-for-longer has been the right call in recent years but now the market is starting to appreciate inflation, while central banks are in the midst of a positive and subtle shift. This could lead to negative returns for government bonds and rising volatility. This is why we believe flexibility in fixed income is so important now.