Inflation Pressure and Complacency About Interest Rate Risk

October 24, 2016

Inflation Pressure and Complacency About Interest Rate Risk Photo

For the past few weeks, I have been writing about my concern for fixed income prices (yields rising) over the coming months. U.S. long bonds are on pace this month for their weakest performance since June 2015, according to Bloomberg. I have been asked several times recently why I am growing more concerned about fixed income valuations given my long-term view that rates will remain low for a prolonged period of time. There are several reasons why.

The last several years have seen incredible pressure building for investors to buy longer maturity and riskier fixed income assets as a search for yield has become rampant across the globe. With $10 trillion of bonds trading at negative interest rates globally and the interest rate risk in bonds (duration risk) increasing due to issuance and lower yields, the potential for negative price performance has increased.  The pressure for yield-starved investors, insurance companies, pension funds, banks, etc. has built to a tremendous level. As the longer yields remain low, the larger the pressure becomes on these types of investors, as the higher yielding assets mature. Many investors have expected yields to rise and have been caught off guard with the fall in government yields and the dramatic tightening of credit spreads during 2016. This has created a frenzied buying of fixed income assets in both the cash bond market and in derivative form. This buying has led fixed income assets to perform very well this year, with the longest duration and weakest credit profile outperforming.  Check out the negative swap spreads at the long end of the yield curve as a good indicator of the demand for duration.

On the economic fundamental side of the equation, I am still optimistic that global growth will remain positive and that the U.S. economy will continue to chug along at its current level of growth. The biggest fundamental change that has occurred recently is the building inflation pressures that have been creeping into the economy. I expect these pressures to continue into 2017.

On the monetary policy side, the Federal Reserve will most likely raise interest rates in November or December. Additionally, the talk among central bankers that extreme monetary policy actions may have unintended consequences reduces the potential demand to increase asset purchases above current levels.

All of these factors lead me to believe this is a time to be defensive on bonds. The risk with fixed income securities is greater because of the low yields. The potential for large mark-to-market losses (5-20%) exists for longer maturity fixed income assets over the next several quarters.

Tags: Monday Morning O'Malley | Bonds | Inflation | Monetary policy | Interest Rates | Central banks

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