Thursday, 3 December 2020

 

Investors seek inflation protection as economic optimism rises

In the past week, institutional investors accounted for 97 per cent of the new capital committed © Gary Cameron/Reuters

Demand for inflation-protected securities is soaring as investors move to safeguard their portfolios against rising consumer prices given the possibility of a faster economic recovery.

Funds that buy US Treasury Inflation-Protected Securities — known as Tips — recorded $1.8bn of inflows in the week ending Wednesday, the largest amount since June and the ninth consecutive week the funds have been allotted new money from clients, according to data provider EPFR.

Investors in recent weeks have bet easy monetary policy from central banks globally and new fiscal stimulus from Washington will finally push consumer prices higher, while the rollout of coronavirus vaccines next year helps return business activity to normal.

The inflows have been dominated by large institutions like endowments and pension funds. In the past week, institutional investors accounted for 97 per cent of the new capital committed.

And investors have predominantly favoured passive exchange traded funds, according to EPFR, such as the iShares Tips Bond fund. The recent influx has lifted the assets in that fund back to $25bn, a whisker below a record hit in 2018, Bloomberg data showed. 

Column chart of Weekly flows into US funds buying inflation-protected securities ($bn) showing Demand for inflation protection has surged

Market measures of US inflation expectations have steadily climbed. One measure derived from Tips prices — the 10-year “break-even” rate — this week hit its highest level since May 2019, and now sits at 1.87 per cent.

That compares to a current inflation rate of 1.4 per cent, as recorded by the Fed’s favoured consumer price measure, Core CPE. The central bank has a target for Core CPE of 2 per cent, which it has persistently failed to meet. It hit a low of 0.93 per cent this year.

The outlook for economic growth has brightened dramatically in the past few weeks as multiple pharmaceutical companies have announced positive results from their respective large-scale coronavirus vaccine trials. Broad distribution is expected by next year, paving the path for what Oxford Economics sees as “a more rapid lifting of activity restrictions in some advanced economies, and potentially better economic performance from mid-2021”. 

Line chart of US 10-year break-even rate (%) showing US inflation expectations rise as investors eye economic recovery

Tensions have also thawed between Democrats and Republicans over the contours of a new stimulus package, with a bipartisan group of senators unveiling a new proposal worth $908bn this week.

A stronger, more rapid rebound, coupled with a Fed that has signalled a willingness to let inflation run above the 2 per cent target on a sustained basis, has put many fund managers on edge, fearing inflation could erode the real value of already-low returns on bonds.

A number of investment firms have advocated Tips for their clients, including Charles Schwab and BlackRock.

“We are more likely to get more inflation than the market is currently pricing than less over the next several years,” said Bob Miller, head of the US multi-sector fixed income team at BlackRock.


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