Will Inflation Rattle Bond Investors? How to Invest When Rates are Rising

02.15.2018 - Jeffrey S. MacDonald, CFA

Without much fanfare, interest rates have been rising slowly since late last year. But a new tax code, improving economy and recent wage pressures have raised fears that higher inflation could be on the horizon—prompting the Fed to raise rates more aggressively. In this Q&A, Head of Fixed Income Strategies Jeff MacDonald answers the most pressing questions investors are asking about this turn of events.  

Q. Why are interest rates rising?

Jeff: Expectations for continued rate hikes are largely responsible for the recent increase in 2-year Treasury yields, which now exceed 2%, because shorter-maturity bonds tend to be more sensitive to rate hike expectations. But yields on longer-maturity bonds like 10-year Treasuries are influenced more heavily by inflation expectations.

Until recently, modest inflation expectations have kept longer-term yields relatively steady. But the introduction of tax reform in late 2017, along with stronger global economic growth, have recently raised concerns about stronger-than-expected inflation, pushing up yields on longer-maturity bonds. In fact, the yield on 10-year Treasuries jumped to 2.9% on February 14, reaching a four-year high.  

Q. How have changes in supply and demand for Treasury bonds affected yields?

Jeff: On the supply side, tax reform has created a considerable near-term budget deficit that the US government will need to finance, possibly by issuing more Treasury bonds. In addition, the newly-released budget included $300 billion in new spending and a $200 billion infrastructure spending proposal. To fund this higher spending, it is possible that Treasury bond issuance in 2018 and 2019 could be twice the level seen in 2017. 

At the same time, investor demand is fading. The Federal Reserve was a major investor in Treasury bonds after the financial crisis but its role as a buyer is fading as it reduces the size of its balance sheet from a peak of $4.5 trillion down to roughly $2.5 trillion. While this process will probably be gradual, finishing up around 2020, it will systematically reduce demand at a time when the Treasury is ramping up supply. And demand globally is down as well.

Q. Why is the direction of inflation the bigger question for investors?

Jeff: As mentioned, an increase in supply and reduction in demand for Treasury bonds could push rates higher. But the bigger question for fixed income investors is the direction of inflation, which has been running below the Fed’s 2% target despite a growing economy and near-full employment.

But the inflation picture is changing. Wages and prices have begun to show some signs of rising, and fiscal stimulus such as tax reform presents the possibility of additional GDP growth. Anecdotally, a number of companies appear to have raised minimum wages for their employees in recent months. And, labor market data such as job “quit” statistics and unemployment rates suggest competition for workers continues to heat up. A recent report on non-farm payrolls showed that average hourly earnings rose by 2.9% in the past year, which was well above expectations.

All of these developments have contributed to recent fears that inflation could accelerate, and that the Fed might raise rates more aggressively to keep it in check. Finally, several new members of the Federal Reserve Board could promote a more aggressive approach to rate hikes. 

Q. Is there such a thing as good inflation?

Jeff: In simple terms, there are two distinct types of inflation. 
Good inflation happens when stronger demand pushes prices higher, lifts wages and contributes to corporate earnings growth. This type of inflation encourages companies to invest in their businesses and makes it easier for them to pay down debt.

Bad inflation happens when prices rise despite weak consumer demand, corporate earnings and wage growth. In this environment, companies find it more difficult to service their debt and they cut back on capital expenditures.

Government data for the month of January offers a prime example of inflation that investors should be concerned about. The Consumer Price Index increased 2.1% versus January of last year, and retail sales fell 0.3%. While inflation is much too complicated to explain with just two data points, these numbers offer a simple example of the price/demand relationship investors should monitor while trying to determine if inflation might have a positive or negative effect on the markets.

Q. How are we approaching the bond market in this new environment?

Jeff: We have been cautiously managing interest rate risk in client portfolios for quite some time, mainly by limiting their exposure to longer-maturity bonds. Given the length of the economic expansion, low unemployment levels and the likelihood of central banks moving toward more “normal” rates, we do not believe current yields offer investors adequate compensation for moving into longer maturities, which are more sensitive to rising rates.

In our view, allocating a portion of our clients’ bond portfolios to holdings with maturities of less than two years offers principal protection and an opportunity to reinvest the proceeds at higher rates when they mature. While this positioning was a bit too conservative last year, it has been advantageous for our clients during the volatile climate we experienced in early 2018.

We also continue to find opportunities in the corporate bond market, where we favor credit risk over interest rate risk as a way to add yield to client portfolios. Interestingly, corporate credit spreads have remained relatively stable throughout the recent bout of stock market volatility. In the municipal bond market, we believe revenue bonds offer advantages over general obligation bonds, which have been pressured by state and local budget challenges. 

We continue to believe a healthy dose of discipline is warranted with respect to interest rate risk in the current environment. While we expect higher rates in the months to come, we do not expect a near-term spike that pushes the economy into recession. We view a rising-rate environment as an opportunity for clients given our current portfolio positioning.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of February 15, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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