Low Treasury Yields Present a Challenge as Inflation Expectations Rise

As the COVID-related economic weakness that characterized the first half of the year subsides, growth has begun to return as trillions in fiscal stimulus have helped to stabilize consumer spending. Against a backdrop of improving labor market conditions and retail sales, inflation expectations have been on the rise after plummeting in March.

As shown in the LPL Chart of the Day, breakeven inflation, measured by the yield difference between Treasury Inflation-Protected Securities (TIPS) and their nominal counterpart, has been on a wild ride in 2020, and have now returned to levels last seen in February:

View enlarged chart.

In order to fund the historic stimulus measures, the US Treasury has issued record amounts of long-maturity bonds to pay the bill. Taking note of normalizing inflationary pressures following the surprise July Consumer Price Index (CPI) beat, investors demanded additional compensation for growing inflation expectations during the Treasury auction, pushing Treasury yields higher and presenting a potential headwind for future returns.

“Despite record issuance, the yield on the 10-year Treasury is still only trading around 70 basis points (0.70%),” noted LPL Chief Market Strategist Ryan Detrick. “Given such a low coupon, Treasuries will be even more sensitive to fluctuations in interest rates, which presents a challenge to investors looking for high quality options in the fixed income market,” he added. We continue to favor TIPS relative to nominal Treasuries, as rising inflation may pressure bond yields toward our year-end target of 1.0-1.5%.

The uptick in inflation expectations is unlikely to have an impact on the path of future monetary policy, as recent comments from Federal Reserve (Fed) officials have shown a willingness to let inflation run a bit higher than their previous target of 2%. With inflation expectations rising, this may limit the urgency of the Fed to implement additional interest-rate tools to spur growth, but the Fed will likely delay raising interest rates until there is strong clarity that the economy is on a firm footing, which could take a while.

 

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