Investors Flock to Buy Inflation Protection

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Demand for inflation linked bond securities and various types of inflation protection are on the increase, as investor expectations of US inflation hit all-time highs.

Since the beginning of the year, a steady stream of economic news has sharpened investor concerns about the threat of inflation. This data includes increased wage growth, a rebound in the labor market and higher energy prices. These economic metrics indicate growth; they also mean that as the economy improves companies will more easily pass on increased costs.

In fact, investor expectations for inflation over the next five years, as measured by comparing yields on Treasury Inflation-Protected Securities (TIPS) and nominal Treasury bonds, known as the break-even, have hit a new high in their long-term average, at 1.97, and a daily market high on March 13 of 1.86 (See Chart A), levels not seen in a year. 

Chart A: US Inflation Expectations are on the Rise

Created with Y Charts

Furthermore, the intraday price on five-year inflation expectations rose briefly above 2 percent in early March for the first time in seven months, after a report showed the economy added more jobs than forecast in February, according to Bloomberg data.

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality. If inflation averages more than the break-even, the inflation-linked investment will outperform the fixed-rate. Conversely, if inflation averages below the break-even, the fixed-rate will outperform the inflation-linked.

Meanwhile,! the high demand for TIPS indicates investors believe the market is underpricing future inflation. In early March, funds that invest in TIPS took in a net of $359 million, the largest weekly inflow since May 2012, according to EPFR Global. This is the first gain since last April, when Federal Reserve Chair Ben Bernanke's stimulus tapering caused an initial sell-off as investors repositioned their portfolios out of a fear that the economy was weak.

The Data Driving Expectations

Since the beginning of the year, several positive economic reports have bolstered the Federal Reserve's contention that the economy has been improving and no longer needs stimulus. However, the improvement in economic growth also suggests the central bank's efforts have been successful in spurring inflation to achieve its stated goal of reduced unemployment.

Below, we take a look at the numbers behind energy prices, unemployment, wage gains, and consumer confidence to more closely discern the underlying fundamentals that are driving investors’ new inflation expectations.

Energy Prices on the Rise

The single biggest new development that has prompted investors to seek inflation protection this year has been the steady increase in energy prices.

This is a state of affairs that will likely continue, according to Robert Rapier, chief investment strategist at Investing Daily’s The Energy Strategist, our sister publication. Rapier argues that natural gas prices will remain at elevated levels after demand increased for natural gas as a result of the arctic weather that blasted the Northeast and Mid-Atlantic states.

Rapier makes the case for why oil has been stubbornly high and will continue:

“In a nutshell, it's the demand side of the equation keeping pace with the growing supply. Over the past decade, demand in the US and the EU fell, but this was more than compensated for by growing demand in developing countries. This kept the price of oil high, despite s! upply/dem! and fundamentals that in isolated countries would have encouraged lower prices.”

But the world's oil markets aren't local. And now demand in the US is starting to regain strength, recently rising to the highest level since 2008, he argues.

The International Energy Agency has estimated that global demand for oil will increase this year by 1.2 million barrels a day. For perspective, over the past five years the world has increased oil production by nearly 3.9 million barrels (2 million of which was from the US) — an average increase each year of 770,000 barrels per year. “I believe the long-term direction for both commodities [natural gas and oil] is inevitably higher prices,” Rapier concludes.

Unemployment and Wage Gains

As my Inflation Survival Letter colleague Benjamin Shepherd identified last week in his analysis entitled, “The Mixed Picture on Jobs,” the economy added 175,000 new jobs last month and a more-than-expected 129,000 in December, but the unemployment rate actually ticked up from 6.6 percent in January to 6.7 percent in February.

To explain this ostensible discrepancy, Shepherd points to analysis by HSBC as to how inflation becomes increasingly unpredictable after the official unemployment rate falls below 6.5 percent, with inflation about as likely to go up as to go down.

We have long contended (and Federal Reserve Chair Janet Yellen has acknowledged) that one of the challenges of the central bank is identifying the number of unemployed to gauge its monetary policy. The headline number, many have argued, does not seem to be representative of what is going on in the real economy, given the high numbers of long-term unemployed that are failing to be counted. This oversight increases the chances that the Federal Reserve will fail to time its stimulus and contain inflation.

Responding to the higher rate of unemployment that was reported, Vice Chair Stanley Fischer, the nominee to be Federal Reserve Chair Janet! Yellen�! �s top lieutenant, asserted on March 13 that the US economy still needs unprecedented accommodation amid high joblessness.

"At 6.7 percent, the unemployment rate remains too high," Fischer said in remarks prepared for his confirmation hearing before the Senate Banking Committee.

The number of people who applied for US unemployment benefits fell by 9,000 to 315,000 in the week ended March 8, marking the lowest level since the end of November, the US Labor Department reported. Economists surveyed by the Wall Street Journal’s MarketWatch expected claims to total 330,000 on a seasonally adjusted basis. The average of new claims over the past month, a more reliable gauge than the volatile weekly number, declined by 6,250 to 330,500. That’s the lowest level since early December and a reminder that, though sluggish, the economy is improving.

Meanwhile, between discussions of raising the minimum wage and new indications of wage growth, many investors are watching these developments closely and forming new inflation expectations.

The US Bureau of Labor Statistics reported average weekly earnings rose 0.3 percent in March from a year ago, using the data from the consumer prices report to adjust for inflation. That's a static growth rate but wages overall are up since the recession’s start. They’re down from the end of 2008, broadly flat over the past decade, and on an inflation-adjusted basis, wages peaked in 1973, fully 40 years ago. Regardless of these fluctuations, the wage trend points to continued economic recovery.

Consumer Spending on the Rise

Consumer confidence rose last week to the second-highest level since August, as Americans grew more upbeat about the economy. The Bloomberg Consumer Comfort Index climbed to minus 27.6 in the period that ended March 9 from minus 28.5 the prior week. The advance was the fifth straight and the reading was second only to the minus 27.4 in the week ended Dec. 22, which was the strongest since mid-Au! gust.
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Consumers surveyed were more optimistic about the economy than at any time in the last seven months, reflecting stocks near record highs and a labor market that's showing signs of improving, according to Bloomberg. At the same time, “discussions about raising the minimum wage are probably helping lift spirits at the bottom of the income scale,” the Bloomberg report surmised. This improvement in consumer confidence was also confirmed by the widely watched University of Michigan consumer sentiment survey.

The Thomson Reuters/University of Michigan final index of sentiment rose to 81.6 last month from 81.2 in January. The median estimate in a Bloomberg survey of economists called for the measure to hold at its preliminary reading of 81.2. Sustained sentiment indicates spending may pick up after bad winter weather across much of the US caused some Americans to stay close to home rather than shop at the mall.

Furthermore, the Michigan sentiment survey's index of expectations six months from now increased to a six-month high of 72.7 from 71.2 last month. The preliminary reading was 73. The gauge of current conditions, which measures Americans' view of their personal finances, dropped to 95.4 in February from 96.8 a month earlier. The initial reading for February was 94.

Another report from the US Commerce Department in late February showed the economy expanded in the fourth quarter at a 2.4 percent annual rate, slower than initially estimated.

The upshot: The seeds have been planted for higher inflation and you should get ready now.