Bond investors are talking about whether the US is heading into a deflationary mode.
This year’s collapse in Crude Oil prices and the weak economic data are putting the Question front and center as the FOMC meets this week. The Fed is expected to stand pat in here and assess the aid/stimulus programs rolled out in the past month to calm markets, while reiterating a commitment to do more as needed.
But with market-based gauges showing investors see inflation stuck at 50% less than the Fed target for the next 10 yrs, the risk of falling prices is creeping into money managers’ strategies.
We think that there will be a sufficient relaxation of virus chaos restrictions that will allow commercial activity to pick up in Q-3. We do not expect a multiyear deflationary era, but we expect deflation to be seen just over the course of the next year.
The 10 yr breakeven rates, a proxy for the market’s average inflation expectations into Y 2030 have stabilized after slumping in March to the lowest since early Y 2009, following a short time below Zero. They are now around 1.1%, up from as low as 0.47% last month.
The Fed targets 2% inflation and its favored gauge has missed the mark for much of the last 8 yrs. Data this week are expected to show the measure slipped to 1.3% in March, the lowest since November.
The deflation debate is Key for investors.
The experience of Japan shows policy makers may struggle to reverse the phenom of dropping prices should it occur in the US.
When the FOMC cuts rates to near Zero at an emergency meeting on 15 March, policy makers pointed to below-target inflation and the need to lift prices as a reason for the move.
This month, Fed Vice Chairman Clarida said policy makers “have the tools to keep the economy out of deflation.”
A few days later, St. Louis Fed President James Bullard said it is hard to get a good read on inflation at the moment, but there is some risk of deflation.
Bond portfolio managers are not designing their portfolios with the expectation of deflation. However, longer-term high quality bonds, particularly long-term US Treasuries, provide a solid deflation hedge.
What to Watch
- Traders will monitor how the market fares after the Fed reduced the pace of its Treasuries buying again Friday, while Wednesday the focus will be on the Fed and Chairman Jerome Powell’s news conference.
- Investors will also look to the Bank of Japan’s meeting Monday, with the Nikkei reporting officials will discuss unlimited government-bond buying.
- The European Central Bank (ECB) reveals its latest policy decision Thursday.
Have a healthy week, Keep the Faith!
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