On Tuesday, the U.S. 30-year Inflation-protected bond (TIPS) breakeven rate touched 2.2354%, the highest since 2014, while the U.S. 10-year TIPS breakeven inflation rate also reached 2.303%, the highest level since July 2014. Markets are frantically ramping up their bets on inflation.
Rising economic and inflation expectations have brought fire to credit-linked exchange-traded funds (ETFs), as such funds can benefit from rising interest rates and therefore can be counted as a hedge against such expectations.
Data show that these ETFs have attracted more than $3 billion in inflows so far this year, with inflows in the first half of the year the largest for the same period since 2013. the $3.8 billion SPDR Blackstone Senior Loan ETF (ticker SRLN) has received inflows for 24 consecutive weeks, attracting $1.5 billion so far this year, and the $5.9 billion Kingmaker Senior Loan ETF (ticker BKLN) received about $1.1 billion in inflows.
Rising inflation expectations have hit a wide range of assets, from technology stocks to highly rated bonds. High-yield bonds, as well as floating-rate loans and notes, whose interest rates rise in line with benchmark rates, have come under scrutiny.
Expectations of rising interest rates, as well as market moves in U.S. Treasuries and break-even inflation, have been positive for credit assets because duration has not hurt them, according to Dan McClain, a senior portfolio manager in the liquid credit strategies division of Bristol-Myers Credit Group.
“When fundamentals improve, credit assets will also warm up, and we expect credit ratings to be upgraded and inflationary trades to be generated.”
Economists such as former U.S. Treasury Secretary Lawrence Summers believe that the next fiscal stimulus introduced in the U.S. will lead to unstable inflationary pressures, but investors do not agree.
The U.S. break-even inflation curve, which reflects investors’ expectations of inflation, is inverted, with short-term interest rates outpacing long-term rates.
This situation had occurred consistently during the 2008 global financial crisis. The breakeven rate on the two-year U.S. Treasury, a derivative of the inflation-protected U.S. Treasury, is currently around 2.7%, while the breakeven rate on the five-year U.S. Treasury was recently 2.5%. The breakeven rate on the 10-year U.S. Treasury is slightly lower at 2.3%.
This sign suggests that despite the recent approval of a $1.9 trillion fiscal stimulus package by the U.S. Congress, investors believe that any uptick in inflation will fall quickly.
U.S. economist Tiffany Wilding from Pacific Investment Management said the break-even inflation market reflects the Fed’s recent ability to manipulate inflation above target levels, but some economists and market participants have been suggesting that the risk of a 1970s-type outcome is very small.
Monetary policy policymakers are closely watching market indicators of inflation expectations, which have accelerated since the beginning of the year as investors prepare for a stronger economic rebound following the passage of the Biden administration’s rescue plan.
While policymakers and investors agree that the consumer price index will pick up quickly in the coming months, there are differing views on the durability of the price index rebound.
Federal Reserve Chairman Jerome Powell, along with U.S. Treasury Secretary Janet Yellen, want to allay concerns.
Powell recently claimed that any rise in inflation would be neither substantial nor very persistent. Powell stressed that the U.S. economy is still far from the Fed’s average 2% inflation target. The core personal consumption expenditure price index (the most popular indicator for Americans) is currently at around 1.5%.
Gregory Darko, chief U.S. economist at the Oxford Economics Institute, also believes that inflationary pressures will intensify and then subside this year.
Gregory Darko stated.
“After reaching high levels in the spring, inflation will likely fall back, while it will remain above 2% for longer than at any Time during the past decade. By longer-term historical standards, inflation will remain relatively modest and is still far from being out of control.”
Morgan Stanley economists expect the U.S. economy to grow by 7.3% this year, a higher-than-usual increase, with continued upward pressure on health care costs, Home prices and the prices of certain commodities. As a result, they believe the duration of broad-based inflation will be short-lived.
Economists predict that core personal consumption expenditures will increase by a peak of 2.6% year-over-year in April or May of this year and then stabilize at around 2.3% by the end of this year and throughout 2022.
While these expected increases in consumer price spending are temporary, the timing of an upward trend in inflation and a possible early adjustment in interest rates by the Federal Reserve would deal a heavy blow to the $21 trillion U.S. government debt market.
Last month, the trading market came to a halt as bond prices plunged and yields rose sharply. 10-year U.S. Treasuries are now yielding only slightly more than one-year U.S. Treasuries, and analysts believe U.S. Treasury yields will continue to move higher.
Credit Suisse’s Jonathan Cohen expects the yield on benchmark bonds to rise to 1.9 percent by the end of the year, up from an initial forecast of 1.6 percent. Goldman Sachs Group, Societe Generale and TD Securities have also revised their forecasts for U.S. bond yields.
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