- Robert Tipp is the chief investment strategist at $946 billion PGIM Fixed Income.
- Despite growing warnings of inflation risks, Tipp said he’s not worried about an inflation spike.
- He breaks down the factors holding down inflation and shares where to invest amid inflation fears.
- Visit the Business section of Insider for more stories.
While talks of a bubble are brewing in the stock market, the opposite is taking place in the bond market.
The US Treasury yield curve, which measures the difference between long-term and short-term interest rates, has been steepening. A steepening yield curve typically indicates stronger economic activity, rising inflation expectations, and higher interest rates.
Indeed, the 30-year yield briefly surpassed 2% on Monday, a key psychological level last seen in February 2020 at the onset of the COVID-19 pandemic.
The 10-year breakeven inflation rate, which measures the difference between the yield on the 10-year note and its Treasury inflation-protected securities equivalent, rose to 2.22% on Monday, its highest level since 2014.
Both indicators are signaling to bond investors that the markets are confident about the accelerated economic growth ahead, as Democrats in Congress work to secure the passage of President Biden’s $1.9 trillion relief plan and the Federal Reserve signals continued monetary support.
“There’s a decent amount of confidence that the Fed will be on hold for at least a year or two. By definition, that means if rates are going up, it’s going to swing like a door on the hinge,” said Robert Tipp, the chief investment strategist at PGIM Fixed Income, which manages $946 billion in assets.
In addition to keeping the fed funds rate near zero, the central bank is also buying a lot of short- and intermediate-term Treasuries while the Treasury is issuing all along the yield curve, according to Tipp.
“So the Fed is absorbing the Treasury’s instruments at the front end of the curve, but the market has to absorb the Treasury’s issuance at the back end of the curve disproportionately,” he said of the technical factor driving the curve steepening.
How to think about rising inflation risks
With the prospect of highly stimulated economic growth, more economists and investors are also warning about rising inflation risks.
Most prominently, Larry Summers, former US Treasury secretary and World Bank economist, issued a stark warning about the inflationary pressures that Biden’s giant package would set off in a recent op-ed for the Washington Post.
Tipp sees two main drivers of inflation. One being that over the short term, as the economy recovers from the coronavirus-induced shutdown, business activities resume and prices of commodities such as oil and lumber go up, there will be a natural short-term pick-up in cyclical inflation.
However, over the long-term, the combination of an aging demographic in the US and the factors that have kept inflation lower even than what the Fed wanted over the past decade will continue to hold down inflation, he said.
Tipp believes that fears of inflation are a perennial part of the market cycle. But inflation has continued to trend lower or be very stable as the policies of global central banks become easier and easier.
He recalls that following the recession in the cycle from 1989 to 1992, the central bank cut the fed funds rate to 3%.
“People were scandalized because inflation was running at 3% and people thought that would surely be inflationary,” he said. “But the 90s were actually a very disinflationary decade and inflation came down a lot.”
The same fear took hold of investors after the Fed took action in the cycle from 2000 to 2003 post-dot-com bubble, and in the years after the 2008 financial crisis.
“The difficult thing for people to understand, I think, is that while yields are sensibly very low right now, what’s priced into the market is really a pretty steep string of Fed rate hikes,” he said.
However, the Fed’s commitment to low rates could last up to five years even though the markets have already priced in such rate hikes. As a result, investors will probably see those rate hike expectations come down.
Tipp thinks that as rate expectations come down, investors could see Treasury yields stabilize and drop after the fiscal stimulus runs its course in the next three to six months.
“Maybe we’ll end up right back here at 1% or so on the 10-year Treasury a year or two from now,” he said.
How to invest amid inflation fears
Because of his long-term inflation outlook, Tipp does not recommend that investors shift their assets to inflation-adjusted securities to manage a short-term pickup in inflation.
He said they may continue to perform well for another few months but over the long term, they are probably overpriced and bound to underperform.
Instead, he believes that investors should seek diversification and stay the course with their 60/40 portfolio, which refers to a portfolio split between 60% in stocks and 40% in bonds.
As bond yields have fallen across the spectrum since the pandemic, the 60/40 portfolios have been criticized by some investors as a relic of the past. Tipp believes the portfolio allocation method continues to be the best option for long-term investors as bonds help suppress the volatility and add diversification to the portfolio.
For example, the $1.2 billion BlackRock 60/40 Target Allocation fund returned 17.33% last year, according to Morningstar data.
“We’ve been hearing for the whole time that this bear market in bonds has been going on,” he said, “when in fact, investors who have stayed with their long-term allocation have gotten the benefits of higher returns than cash.”
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