Bond investors are not too concerned about a persistent increase in inflation.
Much ink has been spilled over the past quarter on inflation, which has clearly made a resurgence as the economy has begun to recover and strengthen. But there is an ongoing debate as to whether the current inflationary forces will be a short-term or transitory event versus a longer-term return of higher inflation. Federal Reserve Chairman Powell has stated on several occasions that he and the Fed view the current uptick in inflation to be a transitory event tied mainly to supply bottlenecks in many raw materials and input goods as a result of the global economic shutdown in 2020.
As Justin McNichols, CFA noted in his article, commodity inflation has been the primary culprit behind the recent spike in inflation data. Inflation in services (shelter, medical care, education) have contributed to a lesser degree. According to the Fed’s most recent projections, they are now expecting real GDP growth to be +7% in 2021 (up from 6.5% in March). Their projections for the Personal Consumption Expenditure Index (the Fed’s preferred inflation measure) are for +3.4% in 2021 ultimately moderating around their longer-term 2% inflation target over the next few years.
Today, the consensus among bond investors seems to favor the transitory argument. The benchmark 10-year US Treasury bond started the second quarter yielding 1.74% and finished the quarter yielding 1.47%. As of this writing (7/8/21), the 10-year US Treasury yield stands at 1.36%. Falling yields indicate bond investors are not too concerned about sustained increases in inflation and led to bond prices of all issuers and credit qualities to post gains in the second quarter.
However, bond yields are still up substantially for the year-to-date period. The 10-year US Treasury yield started 2021 at 0.93%, so yields are currently up 46% for the year. This is to be expected in the face of a very strong economic recovery underway.
Going forward, the question of transitory or non-transitory inflation will have repercussions on numerous different asset classes and strategies. From our point of view, having an actively managed multi-asset class portfolio with the ability to focus on assets that will benefit from a higher-inflation environment (natural resources, companies with pricing power) as well as those that would benefit from transitory inflation (growth companies) is the best strategy to use in this uncertain environment.