Over the past several years, investor perceptions of the U.S. economy have changed dramatically. Following several years of consistently disappointing economic growth, few now expect a return to the post-World War II growth norm.
Amid the sluggish economic recovery, investor expectations for future inflation have also moderated, but perhaps by too much. Indeed, current expectations for future inflation may be too complacent, creating a potential opportunity in long-dated Treasury Inflation-Protected Securities (TIPS).
Shifting the Focus to TIPS
Three years ago, according to data accessible via Bloomberg, investors were expecting inflation of roughly 2.5 percent over the course of the next decade. Even as recently as last summer, expectations for long-term inflation were around 2.25 percent. However, since the summer, inflation expectations have collapsed. As of December 1, 10-year TIPS breakevens, a measure of investor expectations for future inflation, were below 1.6 percent. While this is nominally above the multi-year low reached in late September, it’s well below the long-term 10-year breakeven average of around 2 percent.
The collapse in investor inflation expectations coincides with a similar recalibration among consumers. In addition to measuring consumer confidence, the University of Michigan publishes several surveys measuring consumer expectations for inflation. The most recent survey suggests that 1-year inflation expectations are at 2.7 percent, down from 3 percent in March. The longer-term 5-year survey has inflation expectations at 2.6 percent, just above a multi-year low.
Why have both investors and consumers lowered their expectations for inflation so dramatically? While the sluggish recovery has certainly contributed, there’s some evidence that the precipitous drop in oil has played an outsized factor. Since peaking last summer, U.S. crude benchmark WTI has fallen by approximately 55 percent, according to Bloomberg.
As consumers and investors are constantly exposed to the price of a gallon of gasoline, itself a function of crude prices, the drop in oil may have disproportionately impacted perceptions of inflation. There’s some empirical evidence to support this. Since the third quarter of 2015, the drop in oil prices explains roughly 80 percent of the variation in 10-year inflation expectations, according to a BlackRock analysis using Bloomberg data.
Should oil prices continue to collapse, inflation may remain at today’s low levels or sink even further. However, there are a number of signs that that the recent drop in inflation expectations may be overdone.
Inflation Expectations Underrated?
First, U.S. inflation stripped of food and energy prices, which are inherently volatile, has been much more stable than the headline number. The core consumer price index (CPI), which excludes both food and energy prices, is currently running at 1.9 percent year over year, the highest level since June of 2014, according to data via Bloomberg.
Looking at this from an economic perspective also seems to indicate that today’s inflation expectations may be unrealistically low. My preferred leading economic indicator—the Chicago Fed National Activity Index (CFNAI)—suggests that current estimates for U.S. inflation appear roughly 40 basis points too low.
While I don’t envision a significant surge in inflation anytime soon, I do expect to see some stabilization in inflation and inflation expectations given factors including declining slack in the labor market. In addition, U.S. inflation should firm as the one-off impact of a stronger dollar and lower energy prices start to fade from CPI calculations.
In the meantime, today’s TIPS prices tell me that investors’ inflation expectations may be too sanguine. As such, in bond portfolios, I prefer TIPS to plain-vanilla Treasuries. An allocation to TIPS could help hedge the risk that inflation may be on the rise.
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