US government bonds: Inflation has no impact (yet)

The risk of a trade war-ignited recession remains at 25%

Markus Allenspach, OpinionIndustry Expert
Markus Allenspach is Head of the Julius Baer Fixed Income Research team and a member of Julius Baers Investment Committee. Markus joined Julius Baer through the acquisition of SBC Wealth Management in 2005, where he had worked in various management positions in Research since 1999. Prior to this engagement, he was Head of Currency & Fixed Income Research at UBS Investment Bank in Zurich. He graduated in Economics at the University of St. Gallen in 1983.

July 17, 2018

U.S. government bonds are trading in relatively narrow ranges. The yield of the benchmark 10-year Treasury note has been hovering in a range of 2.82 percent to 2.88 percent over the past three weeks.

Meanwhile, higher prices for oil, among other things, have pushed the annual rate of inflation to 2.9 percent. For the first time since February 2017, therefore, the reported annual inflation rate has surpassed the 10-year Treasury note yield.

The U.S. bond market is not expecting inflation to remain at the current level for long. Indeed, the 5- and 10-year break-even inflation rates (BEI) remain stuck around 2 percent. The BEI is the inflation rate that balances the return of inflation-linked Treasury securities and conventional bonds and can thus be taken as an indicator of the bond market’s long-term inflation expectations.

The downtrend of inflation expectations confounds the Federal Reserve (Fed) argument that wages and prices will ultimately result in more inflation pressure. It will be interesting to see whether Fed Chairman Jerome Powell shares this argument in the semi-annual testimonies he delivers on Tuesday and Wednesday this week.

We stay positive for Treasury inflation-protected Securities (TIPS) to preserve capital in an environment of rising inflation pressure. Moreover, we maintain our assessment of a 25 percent risk for a growth-negative trade war. U.S. President Trump has hammered out a tax reform against the resistance in his own party and carved out compromises in other areas.

The risk of a trade war-ignited recession therefore remains at 25 percent. We thus see more rate hikes in the pipeline and recommend money market instruments to remain flexible, as well as medium-term, low-investment grade bonds to generate a decent income with moderate risk.

Any opinions expressed here are the author’s own.

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