Doubts that the Federal Reserve is acting slowly in combating inflation are giving investors fresh reasons to buy bonds that protect against accelerating price increases, according to Barclays and HSBC Holdings.
Long-term US Treasury yields climbed to their highest levels in nearly two decades last week. Fed Chair Kevin Warsh, despite repeatedly emphasizing the need to curb rising prices, declined to clarify how policymakers would control inflation, intensifying worries that the central bank may be acting too late.
Meanwhile, volatile oil markets and government spending issues are also unsettling investors. On the other hand, the breakeven inflation rate, a measure of inflation expectations, is near a one-year low.
Strategy for the Current Environment
Jon Hill, Head of US Inflation Market Strategy at Barclays, stated: "The market interpreted this inaction as dovish and with questionable credibility. Following this, I expect the market to price in higher inflation risk along the yield curve. This means breakeven inflation rates will rise, and inflation-linked bonds will outperform traditional bonds."
After the Fed's meeting, HSBC's Dhiraj Narula reiterated his recommendation for long-term US inflation-linked bonds, citing his concern about the Fed's "longer-term commitment to controlling inflation."
Performance of Inflation-Linked Bonds
An index tracking inflation-linked bonds has risen 0.3% this year, still outperforming the 0.7% decline in the traditional sovereign bond index over the same period.
Inflation-linked bonds adjust their yields based on inflation rates, providing protection for investors. The so-called real yield on 30-year US Treasury Inflation-Protected Securities (TIPS), which excludes the inflation adjustment, is currently at 2.93%. It reached as high as 3.04% on Friday, a level not seen since 2008.
Investor Perspectives
Among other investors, Kevin Kidney has increased the inflation-linked sovereign bond holdings of True Potential Investments LLC to about 20% of the firm's total fixed-income investments. He is concerned that central banks, especially the Fed, are comfortable with faster price increases.
Kidney said: "We believe the level of inflation that central banks are willing to tolerate is higher than what they are communicating."
Stefan Koopman, Senior Macro Strategist at Rabobank, put it differently: "The rationale for investing in inflation-linked bonds is not just that inflation remains above 2%. More importantly, 2% increasingly looks like a floor for inflation, not a ceiling."
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