Ten-year treasury rates will rise, but no imminent inflation impact.
When concerns emerged a few years ago about the Federal Reserve withdrawing bond-market liquidity, observers generally anticipated longer-term rates jumping significantly, an occurrence that macro economic factors quickly tempered. Now, with the Fed expecting to raise short-term interest rates as soon as September, there’s less concern about the impact on long-term bonds, and while inflation is unlikely to affect rates until at least 2017, corporates may already be preparing for it.
Some straightforward ways to prepare balance sheets for the impact of inflation include accelerating the issuance of longer-term debt while rates remain at historical lows and buying physical assets likely to provide higher returns in an inflationary environment. According to Dealogic, the first half of 2015 saw the highest volume ever of 10-year corporate bond issuance at more than $133 billion, compared to just under $88 billion the semester before, the record-to-date then, and 20- and 30-year bonds followed a similar pattern.
“It’s easy to say companies are just locking in low rates. That’s true, but some of it is getting ahead of higher rates down the road, and part of that will be inflation-induced,” said Anthony Carfang, partner and director at Treasury Strategies.
Similarly, the first half set a record for corporate acquisitions, which were certainly driven by many companies’ large caches of cash and historically low borrowing costs, but in part also by their desire to purchase physical assets likely to provide returns exceeding anticipated inflation.
Rate predictions
“Unless something goes wrong with the US or global economy, we think the Fed will raise rates in September, skip the October meeting, and raise again in December,” said David Kelly, head of the global markets Insights Strategy Team at J.P. Morgan.
Mr. Kelly added that long-term rates will likely also rise as some investors shift allocations towards less risky shorter-term paper. However, continued strong domestic and global demand for long-term bonds should lead to a flatter yield curve.
The return on the 10-year treasury late last week was a bit below 2.3 percent. That’s a dip from 2.45 percent reached in June, but the rate had dropped as low as 1.7 percent at the start of February and was below 1.9 percent in April.
The market seems to be anticipating a rate increase,” said Robert Johnson, director of economic analysis at Morningstar. “So I’m not sure the 10-year has to go up a lot when the Fed increases rates.”
Still, Treasury rates have been very volatile in recent years, even at the longer end of the curve, and wary economists don’t want to get fooled again. In May 2013, stronger payroll numbers emerged and the Fed suggested tapering its quantitative easing (QE) bond buying. The market was caught off guard by those factors and 10-year rates jumped 136 basis points through September—prompting the first so-called taper tantrum—and then fell by 54 bps when central bank didn’t pull back as anticipated.
Contrary to expectations, rates in the US have remained extremely low, in part because central banks in Japan and the Eurozone have dropped rates even further, prompting increased demand for Treasuries.
A surprise arrival of inflation, however, could prompt a sell-off in bonds and rates to increase more than expected.
Mr. Kelly noted that overall there’s little indication of inflation rising significantly anytime soon, although there are few signs that could change. For example, the Employment Cost Index from the Bureau of Labor Statics, tracking compensation for all civilian workers, rose to 2.6 from 1.8 during the 12-month period ending March 2015. In addition, Mr. Kelly said, while the core consumer price index has changed little year-over-year, at about 1.8 percent, there are signs that rental costs—a big component of CPI—are moving up rapidly.
Mr. Johnson called the Congressional Budget Office’s “Output Gap,” essentially a measure of capacity that compares actual gross domestic product (GDP) to potential GDP, the “best indicator of inflation by far.” He added that the gap between them is slowly closing, and should that continue they’ll cross in 2017, indicating a “serious bout” of inflation at that time.
“If businesses don’t stop with stock buybacks and M&A, and start spending money on some actual new capacity, we’ll have issues with inflation in 2017,” Mr. Johnson said.
For large companies requiring board approval for major changes, 2017 is really just around the bend.
The bond giant Pacific Investment Management Co. (PIMCO) foresees inflation eventually rising to the 2 percent range—not raising any fire alarms, yet. Even so it recommends corporates splitting investments between a bucket of very short-term high quality assets, and buckets of intermediate and longer-term assets that provide successively greater duration risk but also higher returns.
“Treasurers need to think about preserving capital in a nominal as well as a real, or inflation-adjusted sense, and they need strategies that provide ample return to cushion against increasing inflation expectations that could occur,” said Jerome Schneider, head of PIMCO’s short-term and funding desk.
Mr. Carfang said Treasury Strategies recommends adding a fourth bucket of assets, to accommodate regulatory requirements such as margin and collateral. He added that most companies match their fixed assets and long-term liabilities over a very long horizon, and for those there is little that needs to be done now. For a short-term asset such as inventory, however, companies must work along with the heads of business lines to lock in the cost of production.
“These may be regional decisions, because inflation tends to be localized, at least in the initial phases,” Mr. Carfang said.
On the liability side, Mr. Carfang said, companies may want to accelerate components of their long-term capital plans, including debt issuances and acquisitions, before inflation increases costs—perhaps an explanation for the large increases in long-term bond issuance and M&A in the first half.
Companies could also put cash reserves to use by maintaining higher inventory levels, if they think the cost of goods will go up over time.
Mr. Kelly said one point that’s often overlooked is the US economy’s lack of growth in supply. Growth in the labor force and productivity both also remain slow, resulting in US real economic growth over the last decade averaging 1.6 percent, compared to 3.4 percent over the previous 50 years.
That’s less of a problem if unemployment is falling, and new employees are fueling economic growth, but US unemployment is already down to 5.3 percent and could drop as low as 4 percent next year, Mr. Kelly said.
“So we’re about 18 months away from a point where economic growth in the U.S. is going to slow to about 1.5 percent,” Mr. Kelly said. “For investors, the key implication is to make sure they have enough money invested overseas, because the U.S. is going to be a tough environment to make good returns in both stocks and bonds.”