Inflation, Fixed Income and the Current Economic Backdrop


Kevin Gale, Managing Director, Head of Fixed Income

Inflation is not something favored by bond investors as it can lead to a rapid rise in interest rates, which can reduce the principal value of an existing bond. With the passage of the $1.9 trillion stimulus bill, investors are pricing in significantly higher growth expectations for fiscal 2021. Some economists predict Gross Domestic Product (GDP) could rise 8-9% by the end of 2021 as the stimulus takes effect. However, with the higher growth expectations comes higher expectations for inflation.

Since the financial crisis of 2008, the Federal Reserve (Fed) has been ineffective in creating inflation through its easy monetary policy, which has consisted of historically low interest rates and trillions of dollars in bond purchases into treasury bonds, mortgage-backed securities and, more recently, corporate bonds. Instead, the inflation that the Fed has created has primarily been in financial asset prices, including stocks and bonds, but not necessarily in wages or the final price of goods and services.

Is this time around different? Quite possibly it could be, but only time will tell. The market is currently pricing in an average inflation rate of just under 2.50% over the next five years. This is the highest level of inflation priced in the market since just prior to the financial crisis of 2008.

5-Year Implied Inflation

5-Year Implied Inflation
Source: Bloomberg

Why are many investors suddenly expecting higher inflation? On the production side, the simple answer is supply and demand. During the first few months of COVID, a lot of factories were completely closed or forced to work at significantly reduced capacities for several months. However, during the same time, demand remained high or even increased for a lot of products, especially home products such as furniture as people were at home staring at their outdated furnishings all day long. With trillions of dollars in stimulus money and Americans having extra money in-pocket with fewer day-to-day expenses, economic demand remained, just not across the board as consumer patterns changed. As a result, we have seen inflation in some areas but not others. That may be about to change as more of the economy comes back online.

Another area of potential inflation is in wages. Wage inflation could be spurred by the passage of a federal minimum wage increase and increased demand for workers. Since 2009 the federal minimum wage has been $7.25/hr. In the latest stimulus bill, lawmakers considered raising this to $15.00/hr. Though this increase was not included in the final bill, it is expected to be revisited. While many employers have already increased a high percentage of employee wages closer to the proposed $15/hr wage, some have not, especially in the fast food, hospitality and entertainment industries. The potential significant increase in minimum wage could have a profound impact on some prices as companies would likely increase prices to offset their increased costs.

One final consideration in the outlook for inflation is a recent change in how the Fed targets inflation. In September of 2020, the Fed changed the way it views inflation by moving to “average inflation targeting” over time. Officially, the statement said the Fed “will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time.” In the past, the Fed would begin to raise interest rates to try to prevent inflation from running too much above its absolute target rate of about 2%. Under the new averaging policy, the Fed could let inflation run “hot” if it believes it can maintain its 2% average long-term inflation target.

Inflation is an area of the economy that requires continued awareness as an investor and is something the economy has not experienced in over a decade. Unexpected inflation, the kind that defies policy controls, is something that can cause volatility in asset prices (stock and bonds). It is still unclear if the inflation we are seeing is transitory, due to the significant amount of stimulus benefiting the economy, or if it is a long-term issue. Traditionally, hedges against inflation include stocks, commodities, treasury inflation protected securities (TIPS), floating rate bonds, gold and certain real estate investments. Although it is possible that inflation could increase in the coming months, we do not recommend investors put all their eggs in one basket by betting that it will in fact happen. Ancora’s investment professionals continue to recommend investors maintain a well-diversified portfolio to help hedge against inflation but other unknown risks as well.

View All >