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The recent burst of inflation in the US and in many other countries has led investors to wonder whether the entire inflation environment has changed.
Although US inflation is still 2% above the Federal Reserve’s objective, inflation appears to have peaked and is now declining. Measured by the Core PCE index, the Fed’s preferred inflation measure, inflation has declined since February 2022 from 5.2% to 4.1% year-on-year (YoY) (see Figure 1). Within its sub-components, core goods price inflation has fallen to 2.5% YoY. However, core services inflation has declined by a smaller amount to 4.7% YoY, highlighting the fact that inflationary pressures are persistent in parts of the economy.
Recent US economic data have been mixed, making the task of predicting the next few interest rate moves particularly difficult. Jobs growth was weaker than expected in July 2023, with non-farm payrolls rising by 187,00 new jobs. Additionally, data for the previous two months were revised down, pointing to a softening of the labour market. Despite this, the unemployment rate declined marginally to 3.5% and wage growth stayed at 4.4% YoY.
Regarding economic activity, the ISM manufacturing PMI has been in contraction for the last nine months while the non-manufacturing index remains above 50, signalling continued growth in the sector. US GDP grew at an annualized rate of 2.4% in Q2, above the 2.0% registered in Q1. This was driven by consumer expenditure, business investment and government spending, highlighting stronger than expected activity. FOMC members expect that real GDP growth will soften in the remainder of 2023, leading to a small increase in unemployment.
Fed projections signal that it expects to normalise rates at a slow pace. Committee members stated that they anticipate most of the fall in core inflation to occur in the second half of 2023, particularly as housing services prices and nonhousing services are expected to decelerate. Minutes of the FOMC meeting in July also indicated members would be open to additional monetary tightening in the coming months if inflation pressures persist.
However, according to recent data, financial market participants expect the Fed to remain on hold until the end of Q1 2024, with the next rate cut priced-in for May 2024. Markets anticipate a faster adjustment than the Fed, pricing in around 100bps of rate cuts by the end of 2024 (see Figure 2). In any case, the pace of policy normalization will be determined by developments in economic activity and labour market pressures in the coming months.
The inversion of the US government bond yield curve – the fact that yields are higher at the short-end of the curve than the long-end – could provide an interesting opportunity (see Figure 3).
For example investors could buy a US Treasury with a short tenor, given the elevated short-term yields, and reinvest the proceeds at maturity. However, there is a chance that the proceeds of a maturing Treasury bill in one-year’s time could be reinvested at a lower rate.
An alternative is to endeavour to lock-in current yields for a fixed period with a vehicle that combines features of individual bonds, such as the regular income payments and the time horizon fixed to the specific maturity date, and the diversification of a portfolio of multiple securities. This strategy could reduce the reinvestment risk over the fixed period, based on the current outlook for default rates in fixed income for both investment grade and high yield credits (see Figure 4).
Looking at a hypothetical three-year period, an investor could follow a roll-over strategy, purchasing a 1-year US Treasury bond to benefit from current yields and then reinvest at maturity into another Treasury of the same maturity, repeating the process until the end of the investment period. If rates were to stay at current levels, then the projected total return of this strategy over a three-year period would be around 19%. Alternatively, if rates fall by 100bps, as markets are currently pricing in, then the return of this roll-over strategy would decline to around 14.5%. Conversely, if rates increase by 100bps then the overall return of this strategy would also increase. The projected return for the entire period under these three scenarios is reflected in the navy bars in Figure 4.
Alternatively, if investors lock-in an estimated yield of 6% for the three years of the investment period through a fixed maturity product, then the total return is estimated at 20.8%. In addition to this, the product reinvests the proceeds of bonds which mature before the end of the fund maturity, producing the expected returns reflected in Figure 4.
To conclude, the current economic situation in the US points to a declining inflation rate in the rest of 2023, which will signal the end of the interest rate hiking cycle. Although activity levels have been better than expected, weakening data for the labour market is starting to show the cumulative effects of monetary tightening over the past 18 months. Given the context of elevated bond yields and the inversion of the term structure of US interest rates, one potential alternative to a roll-over strategy is to endeavour to lock-in a high level of yield for a three-year period as part of a diversified bond portfolio.
