Five Wild Cards for 2021
BOND MARKET INSIGHTS

Tempting FAIT

BlackRock’s quant bond experts tackle some hard questions around the recent inflation data. What is behind the headlines? Are rising prices just temporary or the start of something bigger? What does greater inflation uncertainty mean for bonds and 60/40 portfolios?

Key points

01

Greater short-term inflation uncertainty

The first signs of inflation have bubbled up in the market. It is unclear if inflation will be sustainable, but the risks of entering a new inflationary regime need to be considered.

02

Putting the Fed to the test

Many see a return to the pre-COVID environment of secular stagnation. But a breakout to higher inflation would put the Fed in a bind between promoting full employment and proactively reigning in inflation.

03

Bonds may not diversify

History shows bonds can fail to offset equity losses in periods where inflation fears rise. A reflationary reset requires a rethinking of fixed income allocations given that they have been a key beneficiary of long-running deflationary trends.

In 2020, the US Federal Reserve (the Fed) announced a major shift in policy towards inflation management. Under this new policy, called Flexible Average Inflation Targeting or FAIT, the Fed now targets a 2% inflation on average over time, as opposed to preemptively fighting inflation as it pops up. Since the Fed has undershot their inflation target of 2% over the last decade, they now are going to attempt to overshoot the 2% goal.

But with the first signs of price pressures popping up and historic levels of fiscal and monetary support boosting the economy, is the Fed “tempting FAIT” by assuming inflation is just transitory?

Inflation Conflation

The successful reopening of the U.S. economy has reignited economic activity. For markets, the restart pushed inflation expectations up as measured by nominal and TIPS break-even inflation rates as well as steeper yield curves, and inflationary beneficiaries in the stock market. At the same time, we have seen a rising chorus of debate around the future of inflation, and a flurry of inflationary upside surprises is adding to that discussion. Two major measures of inflation, the Consumer Price Index (CPI) and Core Personal Consumption Expenditures Price Index (Core PCE), have been posting readings well above the 2% Fed target and higher than they have been in decades.

But it's important not to conflate inflation with significant one-time adjustments in prices. Price spikes have been particularly apparent in areas like home building materials, new and used car prices, travel and leisure expenditures, and other areas tied to the economy reopening. Broad-based inflation, in contrast to these headline grabbing increases in prices, is boring. It is persistent and small increases in prices across all categories in the economy that characterize an inflationary increase.

The figure below highlights Core PCE, the Fed’s preferred basket to measure inflation, and the Dallas Trimmed Mean Core PCE (Core PCE Trimmed), a measure of inflation that takes into account outliers in the inflation basket. As you can see, Core PCE data shows a significant increase in overall prices, but the Core PCE Trimmed shows much more stable prices closer to the 2% level. The key to watch going forward will be broad-based price increases, not attention grabbing headlines. This may be the reason fixed income markets have been held largely in check.

Read between the inflation headlines
Controlling inflation measures for outliers

Chart of Core PCE Index and Dallas Trimmed Mean Core PCE Index. It shows that once you eliminate some of the more volatile components of the inflation basket, you find that inflation is closer to the 2% long-run average. Core PCE is about 3% while Core PCE Trimmed is 1.8%.

Source: Bloomberg, as of June 8, 2021. Based on the Core Personal Consumption Expenditures Price Index (Core PCE) and the Dallas Trimmed Mean Core PCE Index (Core PCE Trimmed).

Is the Fed tempting FAIT?

For risky assets—credit and stocks—how the Fed would react to the upside inflation scenario remains key. The Fed’s June FOMC meeting comments displayed a degree of “risk management.” To the surprise of markets, the Fed subtly upgraded its inflation expectations by signaling two hikes by the end of 2023 and acknowledging the beginning of “talking about talking about” tapering. Despite these shifts, the Fed still appears willing to “tempt FAIT” on inflation, as the benefits of pushing nominal rates further from the zero lower bound helps to restore its ability to operate monetary policy effectively and helps it avoid becoming a permanently less effective central bank that cannot fight off future recessions.

However, the costs of letting the U.S. economy overheat now may prove to be more than the Fed currently anticipates. The Fed cites the recent history of low levels of inflation even with low unemployment as supporting its policy stance of pushing the economy further, overheating labor markets and no longer preempting inflation through policy tightening. The Fed no longer forecasts inflation for making policy decisions, it will wait until that inflation actually shows up, confident in its ability to deal with rising inflation.

Yet the very dynamic that allows for this confident view is also its potential fatal flaw. As Larry Summers pointed out, the low inflation response to labor markets (e.g. the "flat Phillips Curve") can be a double-edged sword—as rising inflation may require substantial increases in unemployment to reign it in. In such a case, the Fed might find itself having to choose between rising inflation or large increases in the unemployment rate. Neither outcome would be popular and would unwind many of the benefits of the Fed’s current policy objectives of “broad-based and inclusive” full employment.

A one-time price reset… or the start of inflation?

While the Fed and most economists agree that these price pressures are fleeting, the risks of entering a new inflationary regime cannot be ignored.

Long-term inflation results when the aggregate demand in the economy exceeds the ability of production to keep pace—essentially when demand is greater than supply. The persistent lack of aggregate demand relative to abundant supply in the decades preceding COVID resulted in a prolonged period of disinflation, but several forces may now be shifting the old regime.

A paradigm shift in policy support

The economic support to COVID has been enormous. First, monetary policy by the U.S. government has provided historic increases to liquidity and money supply in the financial system, in addition to direct credit and financial normalization support to markets. Second, we also have seen equally historic fiscal policy support amounting to over $5 trillion in the form of direct payments, payroll subsidies, extended unemployment insurance, child tax credits and more.

The figure below highlights the sheer magnitude of the economic stimulus injected into the economy. It charts the annual U.S. fiscal deficit with the increase in Fed’s balance sheet as a percent of GDP. The amount of both fiscal stimulus and easy monetary policy is the highest it has been in the modern era and on the same levels as World War II.

A new paradigm in policy support
Federal deficit and balance sheet as % of GDP

Chart of the current U.S. Federal balance sheet and deficit as a percent of the U.S. GDP. It shows that currently the Fed’s balance sheet is about 35% the size of the U.S. GDP and the deficit is about 20% of U.S. GDP.

Source: Bloomberg, as of May 27, 2021.

(Sluggish) supply and (pent-up) demand

For some, this level of fiscal support has led to more than 100% replacement rates of lost income during the pandemic. For many consumers who remained employed, they most likely did not spend as much throughout the pandemic given reduced mobility and business shutdowns. The result has been a rapid and epic surge in consumer savings rates alongside surges in consumer spending as the economy has reopened (see figure below). Since February 2020, the excess savings is likely around $2.5 trillion or about 15% of annual consumer spending.

This surge in demand has corresponded with difficulties reopening the supply side of the economy, leading to bottlenecks.

Pent-up demand and cash burning a hole in consumer’s pockets
U.S. disposable income vs consumer spending

Chart of the U.S. disposable consumer income and spending. The chart shows that since February 2020, the excess savings by consumers is likely around $2.5 trillion or about 15% of annual consumer spending.

Source: BlackRock Investment Institute, Bureau of Economic Analysis, U.S. Treasury Department, with data from Haver Analytics, April 30, 2021. Chart shows U.S. nominal household disposable income (orange line) and nominal personal consumer spending (yellow line).

A potential shift from “demand-pull” to “cost- push” inflation

Of potentially greater concern than restart supply and demand dynamics is the labor market. Despite disappointing headline payrolls reports over the past few months, wage inflation figures surprised to the upside. This matters because restart economics and supply bottlenecks reflect “demand-pull” inflation. This type of inflation is transitory because the excess demand will eventually wane as pent-up spending behavior and fiscal support normalizes.

The risk for more durable inflation runs through a transition to “cost-push” inflation. Evidence of this transition is mounting, particularly in the survey data from small businesses which highlights the potential for pricing power pass-through not seen in decades. The figure below shows that about half of firms are planning on raising sale prices and roughly 60% are having problems hiring and filling positions. In this form of “cost-push” inflation, rising wages help bolster the ability of firms to pass on price increases to end consumers, while rising prices and a shortage of labor emboldens workers to demand higher wages.

That is a vicious spiral of de-anchoring inflation expectations that can ultimately lead to persistent—not transitory—pricing pressures.

Start of a “cost-push” inflation cycle?
Firms reporting raising sale prices and hiring shortages

Chart of the percent of small businesses that say they are raising their sales prices and who are finding it difficult to hire employees. Half of firms are raising sales prices, and about 60% are finding it hard to hire qualified workers.

Source: Bloomberg, National Federation of Independent Businesses (NFIB) survey data, as of June 8, 2021.

What does inflation risk mean for bond ballast?

Based on history, we have found that bonds hedge growth scares, not inflation risks. In fact, of the 25 years with negative equity returns since 1929, U.S. 10-year Treasuries generated positive returns in 22 of those periods. In these cases, the rule of thumb, “Bonds go up when stocks go down,” applied.

But what about the other 3 years? Two of the three historical exceptions were unique events. Among the causes in 1931 were the collapse of Austrian bank Credit-Anstalt and the currency crisis that forced Britain to abandon the gold standard. In 1941, it was the U.S. entry into World War II. But the 1969-70 episode stands out. In that period, excessively loose monetary policy coupled with late-cycle fiscal stimulus led to a decade of higher inflation.

Bonds hedge growth, not inflation risks
U.S. stock vs. bond returns in years with negative stock returns, 1929-2020

Alt text: Chart of the years where the stock market declined and shows the total return and price return of bonds. In 1969, bond returns did not offset the negative returns of stocks. This is due to the large price decline in bonds because of the fear that inflation would rise.

Past performance is not a reliable indicator of future results. Source: Bloomberg, as of June 2021. Notes: The price and total return of bonds are based on the annual return of 10-year U.S. Treasury bonds. Stocks are represented by the S&P 500 Index. Price returns are estimated based on the duration of bonds and the movement of the 10-year rate over the year.

What we can learn from 1969

While the restart from COVID is truly unique, a closer look at the late 1960s reveals some parallels with today’s economic backdrop. Inflation was on the rise after a prolonged period of languishing well below the Fed’s 2% target. At the same time, the economy was receiving a hefty boost of fiscal stimulus from President Lyndon Johnson’s Great Society programs and Vietnam War spending even though the economy was near full employment.

In the mid-1960s, as signs of price increases began to emerge, the Fed quickly shifted from inflation-creating to inflation-fighting mode, contributing to a market downturn (see figure below). Under such a scenario, bonds were able to provide a hedge to equities eventually, but only after the Fed had sufficiently snuffed out inflation. Unfortunately for investors at the time, inflation kept climbing and peaked only in the mid-1970s. Further policy errors throughout the 1970s contributed to the dreadful experience of markets.

Fed’s inflation response leads to the 1969-70 recession
Core PCE, Fed Funds Rate and Recessions

Chart of the fed funds rate and inflation from the years 1960 to 1972. The chart shows that as inflation began to rise in the mid-1960s, the Fed raised rates aggressively to stop it. The raising of the fed funds rate resulted in a recession in 1969 and 1970.

Source: BlackRock calculations based on data from Bloomberg, from 3/31/1960 - 12/31/1971. Recession marked from December 1969 – November 1970.

The recession of 1969-70 and the negative stock and bond returns of 1969 that proceeded it highlight what may happen to bond ballast in an overheating scenario. The key lesson: bonds hedge stocks during downturns when the source of the downturn is a growth shock, which typically leads to declining inflation expectations. But when stocks decline due to rising inflation concerns, bonds suffer as well, undermining their role as portfolio diversifiers in a 60/40 portfolio.

The bottom line on inflation

The uncertainty around inflation expectations is likely to be a reoccurring concern for investors as more data becomes available in the coming months. For investors who don’t have the risk appetite to "tempt FAIT," supplementing your traditional bond allocation with alternative diversifiers may be prudent.

Traditional core bond exposures can help to balance equities in the case of a growth shock but are vulnerable to exacerbating portfolio losses in the case of an inflation surprise. A complementary allocation to more defensive-orientated alternatives with less inflation vulnerability may help to better balance equity portfolios if the economy shows signs of overheating and inflation proves not to be transitory.

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Jeffrey Rosenberg
Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...
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