The Federal Reserve’s recent launch of a third round of open-ended bond purchases, or quantitative easing (QE), coupled with more aggressive communication are significant new steps toward the reflationary goals it set in January. As a result, the Fed’s actions are likely to have implications for Treasury Inflation Protected Securities (TIPS), the inflation-linked bonds issued by the U.S. Treasury.
When the Fed introduced its inflation target of 2% in January, we suggested purchasing 10-year TIPS at a real yield of -0.20% and a breakeven inflation rate (BEI) of 2.15%, given the Fed’s desire to loosen financial conditions by lowering real interest rates. We argued then that the 2% PCE inflation target could be the “first in a number of steps to ease monetary policy in an attempt to reflate the economy.” (See “TIPS for Financial Repression,” January 2012.) Although the real yield on 10-year TIPS is currently 60 basis points (bps) lower at -0.80% and the BEI is 30 bps wider at 2.45%, we still find the asset class relatively attractive. With nominal interest rates close to the zero bound, we believe QE3 will lead to even lower real yields and higher inflation expectations, an attractive scenario for investors in TIPS. (The principal, or face value, of TIPS moves one-for-one with inflation as represented by the Consumer Price Index, not seasonally adjusted, while the interest rate remains fixed, though interest payments rise if principal rises or fall if principal falls.)
Implications of QE3 for real rates
With QE3, the Fed conditionally committed to purchasing an additional $40 billion in agency mortgages every month and stated in its September 13 announcement, “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.” The Fed also extended its exceptionally low federal funds rate guidance through at least mid-2015, while adding, “A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” These pronouncements clearly reveal the Fed’s policy bias and tilt the balance towards a focus on its employment mandate at the potential expense of its inflation mandate over the short run.
By purchasing agency mortgages and extending the maturity of its Treasury bond portfolio, the Fed is lowering interest rates, suppressing volatility and buoying inflation expectations, thereby lowering the longer term real interest rates on mortgages, Treasuries and all other instruments that move with these benchmarks. All else equal, lower long term real interest rates raise asset valuations by lowering their discount rates, and can potentially generate real growth by lowering the opportunity cost of financial savings by encouraging investments in homes, plants and equipment, and infrastructure. Through higher inflation and higher inflation expectations, the Fed hopes to turn savers into investors and spenders.
The Fed’s repressionary monetary policies (lowering real interest rates) are also an elegant way to reduce the current public debt overhang. With a substantial share of U.S. government debt held abroad, the government likely finds it politically more palatable to reduce the real cost of paying back debt via higher inflation rather than via higher taxes.
During the Jackson Hole 2012 Economic Policy Symposium in August, Fed Chairman Ben Bernanke was unambiguous that the Fed is targeting lower real yields: “Large-scale asset purchases … can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms.”
Through lower real rates, the Fed is attempting to provide more stimulus to nurture and strengthen the recovery. The U.S. economy continues to grow at close-to-stall speed and is facing both external and domestic headwinds, including recession in the eurozone, slowing growth in China and the looming “fiscal cliff” of U.S. spending cuts and higher tax rates due to take effect at the end of this year. The Fed is constrained by the zero bound on the fed funds rate, and when long-term nominal rates have little room to go lower, price stability becomes less of an objective and more of a tradeoff for achieving other goals, such as higher economic growth and employment. To make a long story short, when nominal rates can’t be lowered in order to lower real yields, you have to tolerate higher inflation and inflation expectations.
Figure 1 illustrates the drop in five-year real interest rates over the past three years. While five-year nominal yields can’t fall much more because of the zero bound on interest rates, higher inflation expectations will likely lead to lower five-year real yields. Currently, the five-year TIPS real yield is around -1.5%, which can be broken down into a five-year nominal yield of 0.6% minus inflation expectations at 2.10%. If inflation expectations rise to 3%, the five-year real yield would fall to -2.4% if nominal yields remain unchanged.
In our view, what was especially interesting about QE3 was that it was initiated despite inflation expectations, as measured by the TIPS market, on the higher end of the range considered consistent with the Fed’s 2% inflation target. Furthermore, the Fed clearly stated that it will maintain highly accommodative monetary policy “for a considerable time after the economic recovery strengthens.” In our view, the Fed’s strong commitment is in reality a subtle way to tell the markets that inflation is less of a target and more of a tradeoff for medium-term monetary policy aimed at increasing economic growth.
Investment implications of QE3
What does all this mean for asset markets? If the Fed is targeting lower long-term real interest rates, investors should look for assets benefiting from lower real interest rates. TIPS are an obvious candidate, along with more volatile assets, such as real estate and commodities (specifically gold).
At PIMCO, we find the volatility of inflation expectations, which essentially measures investors’ uncertainty over the rate of inflation, a useful tool for finding potentially attractive investment opportunities.
As Figure 2 shows, the Fed’s introduction of a formal 2% inflation target in January had a calming effect on the TIPS market, and inflation expectations volatility went down. However, since the announcement of QE3 and the Fed’s commitment to maintain low rates into 2015, the uncertainty of the inflation outlook has doubled and is back to levels seen at the beginning of the year.
Even if the Fed is committed to maintaining a 2% medium-term inflation target, we believe higher inflation expectations volatility in the short term should lead to a higher inflation risk premium with the Fed committed to clipping left-tail deflationary risks. The Fed is committed to growing the economy. If the Fed cannot generate real growth, it will generate nominal growth – higher inflation is one way to generate the latter in the absence of the former.
In our view, TIPS and real assets offer welcome hedges to these growing and asymmetric inflation risks. Although we do not expect TIPS to provide annual double-digit returns, we believe that in this increasingly long-term reflationary environment they remain an important component in a fixed income investment portfolio.