If Near Term Inflation Threat is Real, Should You Still Own Bonds?

June 21, 2021

The topic of inflation is all the buzz lately. You can't turn on any financial news channel without hearing some reference to "the sky is falling, inflation is running rampant" (or some variation of this). Our last blog entry was also dedicated to this topic.   

Yes, it's true that inflation has continued to surprise to the upside recently: core PCE beat expectations in the US and inflation has picked up in Europe. Earlier this month, the U.S. Labor Department revealed that May’s core consumer price index reading, which excludes food and energy, rose 3.8% on a year-over-year basis, a 28-year high. However, when looking at inflation, one factor to keep in mind on inflation is that 2020 was largely a depressed year because of the pandemic. Thus, year-on year comparisons will show stronger gains. 

Many of the worst-affected services are rebounding, gathering momentum, as are their prices. There are a number of supply chain constraints and shortages that really extend to pretty much everything – lumber,  semiconductors, containers, etc. all of which are fueling higher prices. Other factors contributing to inflation include rising housing prices, healthcare costs, potential re-regulation of manufacturing, loose monetary policy and financial asset purchases by the Fed, along with the explosion of government debt and tight labor markets.

Economists overall expect full year CPI to rise 2.8%, with a similar 2.7% gain in the personal consumption expenditures (PCE) price index – well above the Fed’s 2% target but trending down through the year towards 2% for both the PCE and core CPI by the fourth quarter.

Reflation's Effect on Bonds

Reflation is the first phase of economic recovery when inflation is recovering to a “normal” level after a slump. This setup is often good for stocks, especially in certain sectors. But it puts some bond investors in a bit of a situation in that bond prices tend to fall is rates go up.

For example, say you’ve bought a 10-year Treasury that entitles you to 1% interest payments until the bond matures. After a while, demand for these bonds falls and the US Treasury auctions off the same 10-year bond, but with a 1.5% interest rate. All of a sudden, the price of your bond goes down. That’s because investors would rather buy the newly issued bond that pays 1.5% in interest vs. your 1%. However, if you hold your bond until it matures, its market price won’t affect you. You’ll keep earning 1% in interest and get back your original investment after 10 years. But if you sell the bond, you’ll have to offer it at a discount to match the income potential of the newly issued bond. Otherwise no one will buy it.

Given that backdrop, higher inflation and rising yields have some investors questioning whether they should stick with bonds.  However, it would be a huge mistake for investors to simply abandon their bonds using that singular lens.  For more on this check out this great post by Capital Group that expands upon the idea that bonds are still important to own for many investors.

Undoubtedly, 2021 is shaping up to be one of the more challenging years for fixed income investments in recent times. Even so, reports of the bond market’s death are greatly exaggerated. It’s no time to listen to the bond bears: Owning bonds in this kind of environment remains as important as ever.

As our colleagues explained in their U.S. outlook and its international counterpart, economic growth is expected to be strong. However, that strength will not be uniform across regions and sectors. The recovery has global policymakers on both the fiscal and monetary side curtailing their unprecedented COVID-19 stimulus. For central bankers, in particular, that normalization process will likely be gradual. They must consider the risk of upsetting the financial market as the recovery unfolds.

Check out the entire post here.