With the Federal Reserve injecting more money into the financial system via a second round of quantitative easing known as QE2, should investors fear inflation? Or is deflation still on the horizon? Mihir Worah, portfolio manager, and John Cavalieri, product manager, outline PIMCO's views on the direction of price levels, while highlighting inflation hedges.
Q: Much discussion recently has centered on evaluating inflation versus deflation risk. Where does PIMCO fall on the inflation-deflation debate in the near-term?
Worah: In short, we are not in the deflation camp. In the near-term, while we don't see run-away inflation as an imminent risk, we also don't see deflation in our base case. We see near-term inflation stabilizing around the current 1% level, anchored by stabilizing rental prices in the core CPI. Even though markets were expecting a V-shaped recovery and higher inflation early in the year, we remained guided by our New Normal views. Specifically, we saw the triple forces of de-leveraging, de-globalization and re-regulation creating a structural headwind to growth. With waning fiscal stimulus that in Q3 2010 actually became a net drag, our view was that an L-shaped recovery, characterized by lackluster growth and modest disinflation, was most likely. And that's just how things played out.
Even if deflation occurs, we think it will be relatively mild, short in duration and likely driven by some shock to aggregate demand. When inflation is at 1%, it's not too difficult to get below zero, but that doesn't mean we have systemic, structural deflation like in Japan. In August 2010, our co-CIO Mohamed El-Erian received some attention in the press by estimating the probability of deflation at 25%. With the Fed now bringing a second round of quantitative easing and being aggressively dovish in its rhetoric, that probability has meaningfully declined. In addition, in prior Secular Forums we identified other drivers of longer-term inflation risk that are independent of today's extreme levels of monetary stimulus.
Q: How is the inflation vs. deflation debate impacting the market for Treasury Inflation Protected Securities (TIPS)? And why are we seeing negative real yields in TIPS?
Cavalieri: The TIPS market continues to signal expectations for positive inflation, not deflation. 5-year break-even inflation levels are around 1.5%, and 10-year inflation expectations are around 2.1%. Both of these levels have risen modestly over the last several weeks as the market has priced in the likelihood of QE2.
With respect to real yields, the market's diminishing expectations for a V-shaped recovery has been positive for TIPS investors. TIPS, represented by the Barclay's Capital U.S. TIPS Index, returned 9.8% in 2010 through the end of October, as 10-year real yields fell 1% over that time to 0.4% today. Falling real yields have been driven both by fundamentals "“ reduced real GDP expectations and heightened risk aversion "“ and by technicals "“ notably expectations of continued quantitative easing. The combined effect has actually driven real yields into negative territory through the seven-year maturity point.
While negative real yields have raised a number of questions, the reason is very straightforward. Short-term real yields are negative by policy design "“ the Fed wants to create a penalty for holding cash, or said differently, to create an incentive for greater risk-taking in order to increase economic activity. So the Fed took the overnight nominal rate to zero. Combine a zero nominal rate with positive inflation expectations and the result is negative real yields. It's just simple arithmetic: nominal yields less inflation expectations equal real yield.
Q. How does the existence of negative real yields in TIPS affect TIPS auctions?
Worah: The recent five-year TIPS auction on October 25, 2010 was unique because it was the first TIPS auction to price with a negative real yield. On paper, TIPS are set with a positive coupon, in this case 0.5%. The bond then prices at a premium in order to lower the real yield to maturity down to the market level, which on that day was roughly -0.5% for five-year maturities.
Q. Are negative real yields unique to TIPS?
Cavalieri: No, negative real yields are not unique to TIPS, they are simply observable in TIPS. TIPS are quoted in real yield terms, whereas most other bonds are quoted in nominal yield terms. So the level of real yields that investors see in TIPS is actually implicit in nominal Treasury yields and, therefore, in all fixed income sectors that price off Treasuries. The bottom line is that TIPS are not unique in offering low yields today. Yields are low across domestic fixed income sectors, which, again, is by policy design.
Q: What are the key details of QE2, and what are the implications for TIPS and other sectors?
Worah: The Federal Open Market Committee announced on November 3, 2010 its intent to purchase $600 billion of "longer-maturity Treasury securities by the end of the second quarter of 2011." The Fed also plans to continue reinvesting principal payments from agency debt and agency mortgage-backed securities into longer-term Treasury securities, which should increase the total asset purchases by $250 billion to $300 billion over the same period. Lastly, the program will allow for purchases across the 30-year maturity spectrum and will target an average duration between five and seven years.
We interpret these actions as having three goals: First, to lower the real cost of capital throughout the economy by effectively capping real yields, which means buying intermediate to longer maturity TIPS where real yields remain positive; Second, to cap the level of nominal yields by buying Treasuries, since corporates and mortgages ultimately price off the nominal yield curve; And third, to put a floor under inflation expectations, which is the difference between real and nominal yields, so that low inflation expectations do not become self-fulfilling.
These are positive developments for TIPS. It means that investors do not have to be as afraid of holding duration "“ real or nominal "“ as these low yield levels would otherwise suggest. While it's unrealistic to expect significant price gains from here, we believe real and nominal yields will be supported within a range by the Fed and its printing press for some time. It also means investors should consider favoring TIPS to nominal Treasuries, since the policy goal is to increase inflation expectations, and, ultimately, actual inflation. At some point in the future as QE2 abates, all bond sectors will face the headwind of rising yields. However, TIPS will likely continue to outperform nominal Treasuries since TIPS do not have price sensitivity to rising inflation expectations; TIPS pay actual inflation instead.
QE2 has implications for other asset classes as well. Broadly speaking, QE2 should also support risk assets. This means corporate bonds, high yield and equities stand to benefit, at least initially. Longer-term, returns in these risk assets will ultimately be determined by the ability of the economy to regain strength, which remains a concern. Assets that diversify U.S. dollar or U.S. inflation risk should also benefit. We would highlight commodities, high quality emerging market currencies and locally denominated EM assets.
Q: Can you expand on the longer-term inflation drivers that you referred to earlier?
Cavalieri: We see multiple potential drivers of inflation risk over the secular (three-to-five year) and especially the super-secular horizons. People are rightfully concerned over the historically high levels of monetary stimulus in the form of low rates and a vastly expanded Fed balance sheet. We usually see about a two to three-year lag between expansionary monetary policy and the onset of inflation. The eventual removal of that stimulus will be a delicate policy act, especially if the employment situation is slow to recover. Regarding unemployment, we see the potential for wage pressures to increase sooner than historical analysis would suggest. This is because a portion of our currently high unemployment is not cyclical but structural. Some industries are permanently smaller, some people are unable to find training to supplement skills that are increasingly obsolete, and some people are unable to move given negative equity in their homes. In economic terms, this means the non-accelerating inflation rate of unemployment (NAIRU) is structurally higher than the 4-5% range that characterized the Old Normal economy, maybe closer to 7%. NAIRU is the level of unemployment below which inflation rises. The Fed will certainly be challenged to achieve its dual mandate of price stability and full employment over the years to come.
Domestically we also face a deteriorating dependency ratio, which means more elderly consumers per productive workers. This will stress various industries, such as the medical sector, and also our federal entitlement programs, notably Social Security, Medicare and Medicaid. Higher inflation may be tolerated as a politically palatable way to reduce the real value of that massive fiscal burden.
Rising commodities prices and a secularly depreciating dollar will also contribute to inflation, as both raise the domestic cost of essential goods. Commodities require ongoing reinvestment to expand supply, and that has lagged in recent years amid the Global Financial Crisis, despite growing global demand and capacity constraints in some sectors. A depreciating dollar over our secular horizon is driven by differentials in sovereign growth prospects, trade flows and exacerbated by QE2.
Outside our borders, we are starting to see foreign wages meaningfully rise, as high growth emerging economies like China face tighter domestic labor markets. The "global labor arbitrage," which was a powerful disinflationary force in the Old Normal, is lessening and in some markets actually contributing to higher global prices.
Lastly, to the extent that emerging economies seek to stabilize their exchange rate versus the dollar, then they are also forced to import our low level of interest rates into their much higher growth economy. This is often overly stimulative, which can accelerate inflation within these countries and eventually spread across borders.
Bottom line: There are some significant long-term drivers of inflation that paint a much different picture going forward than what we saw over the "great disinflation" of the 1980s and 1990s. This is not to say we are destined to return to the double-digit inflation of the late 1970s and early 1980s, but it does mean the balance of risk is certainly shifting from disinflation to inflation in the years ahead. It also means that the optimal asset mix for the eventually reflationary New Normal is likely much different than what made sense over the disinflationary regime of the past 30 years. At a minimum, we believe investors should consider making larger allocations to inflation-sensitive assets and strategies, which include but are not limited to TIPS.
Thank you, Mihir and John.
Barclays Capital U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Barclays Capital Inflation Notes Index. The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. Core CPI excludes goods with high price volatility, such as food and energy. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This material has been distributed for informational purposes only. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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