Advisors offer 'TIPS' on possible inflation comeback

Key Points
  • In February Fed Chairman Jerome Powell said he was more confident that "inflation was moving up to target" — the target being 2 percent.
  • After driving the 10-year Treasury bond yield up 50 basis points to 2.95 percent in early February, it has since declined to 2.75 percent.
  • Should investors in Treasury bonds consider getting inflation protection? Advisors differ in their opinion.

Is inflation back?

After a decade of trying to stimulate prices in the morbid economy and avoid a deflationary funk, the Federal Reserve has finally returned to its traditional role of inflation fighter.

It may be switching gears too early, said Michael Bazdarich, an economist with Western Asset Management. "I don't see the impetus for higher inflation this year," he said. "The bond market has overbought the inflation and growth story."

Colin Anderson | Getty Images

So has the Fed, according to Bazdarich. In his first testimony before Congress in February, Fed Chairman Jerome Powell said he was more confident that "inflation was moving up to target" — the target being 2 percent. The Fed has indicated it will continue to raise short-term interest rates to make sure inflation doesn't increase beyond that level.

Bazdarich thinks that Fed policies have failed to increase overall spending in the economy — the only thing that he says will lead to higher inflation. He attributed the signs of accelerating economic growth in January and February to seasonal jumps in construction and retailing activity, not to a sustained pickup in the overall economy. Weaker-than-expected job-growth figures in March support that idea.

"We don't see the economy weakening from here, but we also don't see it accelerating," said Bazdarich. "We were in the same situation last year, when [the 10-year Treasury bond yield] rose to 2.6 percent and then retreated back down below 2 percent."

The market seems to agree. After investors drove the 10-year Treasury bond yield up 50 basis points to 2.95 percent in early February, it fell back below 2.75 percent before rising again to 2.91 percent on April 19. Bazdarich thinks it will retreat back down to 2.35 percent this year, regardless of how many times the Fed hikes short-term rates.

Gemma Wright-Casparius, a senior portfolio manager of the Treasury Inflation-Protected Securities (TIPS) funds at Vanguard, is slightly more bullish on the inflation picture.

Between synchronized global economies picking up steam and pushing commodity prices higher, and central banks still accommodative around the world, she expects an uptick in inflation this year.

"We think inflation will peak in the third quarter at 2.7 [percent] to 2.8 percent for headline CPI," said Wright-Casparius.

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The economy appears ready for a rise in inflation. At 4.1 percent for the last five months, the unemployment rate is at its lowest level since 2000. Job growth of 103,000 in March was below estimates, but in large part because of the blowout numbers in February (313,000 jobs created). Wage growth was down a couple of points in February and up a point in March, to 2.7 percent on an annual basis.

Wage increases traditionally have been seen as a necessary factor for overall inflation to accelerate. Despite the tightening labor market, Wright-Casparius does not see it happening.

"We're pretty much at full employment, but I don't see wages rising by more than 3 [percent] to 3.2 percent," she said. "There are structural impediments to inflation. Technology, demographics and globalization all dampen the long-term inflation outlook."

The wild card on the immediate inflation outlook may be how corporations react to this year's tax cuts. Not only has the statutory tax rate on corporate income fallen from 35 percent to 21 percent, but U.S. companies can now repatriate untaxed income stashed overseas at a 15.5 percent rate (8 percent for illiquid assets). While estimates vary, there is likely more than $1 trillion that could flow back into the U.S. economy.

What will companies do with the money?

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"That's the $64-million-dollar question," said George Rusnak, co-head of fixed-income strategy for the Wells Fargo Investment Institute. "Will corporations reinvest the money, pay out higher wages or buy back their own shares?

"We don't have any good signs yet of what they're going to do," he added.

Should investors in Treasury bonds consider getting inflation protection? As of April 17, the 10-year break-even inflation rate in the Treasury Inflation Protected Securities market was 2.14 percent. That means investors are expecting inflation of 2.14 percent over the next 10 years. That has risen from 1.84 percent at the end of November.

Rusnak has gone from an overweight position in TIPS at the beginning of the year to a neutral stance.

"There's been a pickup in inflation expectations this year," he said. "We want to own TIPS when people don't think inflation is coming back."

Rusnak's biggest issue with TIPS, however, is their long duration. Despite the fact that inflation expectations have risen this year — good for TIPS prices — the performance of the iShares TIPS Bond ETF through April 19 was (-0.88) percent) because of the rapid rise in 10-year interest rates. Like most strategists, Rusnak does not see a high risk of accelerating inflation, but he thinks economic growth will rise and so will long-term interest rates.

We're pretty much at full employment, but I don't see wages rising by more than 3 [percent] to 3.2 percent. There are structural impediments to inflation.
Gemma Wright-Casparius
portfolio manager of Vanguard Treasury Inflation Protected fund

"We think TIPS insurance is expensive now," he said. "The long duration aspect is a risk that people don't appreciate."

Rusnak suggested that investors interested in TIPS protection look to the shorter end of the curve to avoid further pain from rising rates.

History shows that the market usually underestimates future inflation rates. If the post-financial crisis economy has finally found its legs, inflation may rise toward the long-term average of about 3 percent. In that case, TIPS could provide valuable protection for Treasury bond investors.

"Fixed-income investors [in Treasurys] who think inflation will be higher than 2.14 percent should buy TIPs, " said Wright-Casparius at Vanguard. "If not, buy regular Treasurys."

— By Andrew Osterland, special to CNBC.com