How to Play Inflation Worries
By Brian Reynolds
Special to TheStreet.com
Originally posted at 9:07 AM ET 3/7/01 on RealMoney.com
Last week, James Cramer penned a column about why inflation shouldn't be a worry now. I've also been arguing that I believe the risks of a slowdown and recession outweigh the potential for higher inflation, but not everyone feels this way.
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The recent debate in Columnist Conversation between Aaron Task and Justin Lahart about the future course of inflation illustrates the dilemma bond investors are facing. The outcome of that debate can have a big impact on how quickly and strongly the economy and stock prices can improve.
Long-term bond yields, set by the forces of supply and demand, can be as important (or even more so) than the short-term rates controlled by the Fed. Corporate-bond yields reflect the cost of financing capital investment, so they are an important variable of the economy's ability to grow.
The Fed generally prefers to follow the bond market. The power of Fed actions is enhanced when bond yields move in tandem with short rates. The Fed was forced to bring short rates down to 3% from 8% from 1990 to 1992, partly because bond yields stayed high as investors questioned whether the Fed was being prodded to ease too much. The result was one of the slowest recoveries from a recession on record.
When bond yields get ahead of the Fed, the impact of easing or tightening can be magnified. During the 1998 Russian crisis, fed funds futures were indicating a much greater decline in the funds rate than the Fed produced.
The Fed didn't have to do more because yields in the mortgage market -- also set by bond investors -- fell so much that a refinancing boom was ignited, leading to two years of extremely strong consumption growth. As the economy strengthened in 1996, futures were pointing to a string of tightenings that never happened because bond yields increased enough to cool the economy.
Investment-grade corporate-bond yields peaked last May and have fallen 100 basis points since then. Pundits will debate forever whether they were indicating an economic slowdown, or whether investors became more confident that the Fed would not let the surge in oil prices let inflation get out of hand. It's something to think about the next time you hear someone bashing the Fed.
In 1999 and the first half of 2000, many of my contacts were worried that the Fed was behind the curve in terms of tightening. For a good part of that period, bond yields rose faster than the funds rate. It is possible to envision a scenario where, if the Fed hadn't tightened as quickly or as much as it did, bond yields could have gone even higher and produced an even bigger slowdown than we are seeing now.
In the chart below, I've shown both the Fed's target for the funds rate and Moody's index of Baa corporate-bond yields. I've shown them on separate scales of equal magnitude to illustrate how the bond market has been leading the Fed the past few years.
Ahead of the Fed
The bond market has been leading the Fed
the past few years
Source: FRB St. Louis
Although bond yields peaked in May, the Fed didn't ease until January. Easing sooner, when oil prices were surging, could easily have spooked the bond market. Within a few weeks of oil spiking down in December, the Fed eased 50 basis points in early January, and another 50 at the end of the month. These cuts equaled the decline in bond yields since May. The big question for investors is: Now what?
It's intriguing to note that investment-grade yields haven't done much of anything since the Fed began easing. Without bonds tagging along, the impact of the 100 basis-point drop in the funds rate is muted, and the Fed will have to do more to get the economy moving again.
Bond investors are worried about a repeat of 1998 when the consumer sector snapped back to life following rate declines. We are already seeing some better-than-expected consumption numbers.
Yes, those numbers are not spectacular and, yes, many sales are being made at discounts. The significance of the numbers is that they show, at the margin, that consumers are willing to spend at the right price. Bond investors are scared that any further decline in yields will trigger a spending frenzy and lead to heightened inflation risks.
However, I believe that any consumption strength is being more than outweighed by tech weakness. I believe that Cramer's analogy of the telcos sector to the savings and loans of 10 years ago is a striking one. I also think there is a good possibility that many investment-grade bond managers don't realize just how bad tech fundamentals are.
When the S&Ls went bust, bond managers could focus on that because finance is the largest sector in the corporate-bond market. Tech, on the other hand, is a lot less important to bond managers than it is to equity investors. Tech, by the end of last year, peaked at around 28% of the S&P.
Depending on how you add it up, tech only accounts for 10%-15% of investment-grade corporate bonds. Most of that tech weighting tends to be in older, more established names like IBM (IBM:NYSE - news), which haven't been as devastated the way that newer tech has.
A few months ago, I wrote about how different units at many investment firms don't necessarily work together. The business has become highly segmented. It used to be that the stock side of the house didn't talk with the bond side. Now, the growth investors often don't communicate with the value investors, and the investment-grade folks don't share information with the junk people. It's easy to focus on your own strand of trees and to not look at the whole forest.
I believe that this might be presenting an opportunity, as bond investors might be underestimating just how bad tech fundamentals are.
IBM keeps making its numbers (though Arne Alsin doesn't believe this will continue), so it's conceivable that an investment-grade manager could think that technology is not too bad off. Cisco (CSCO:Nasdaq - news) is having problems with its inventories, but there is no reason for a bond manager to look at the company's financial statements because it is not a player in the debt markets.
James Cramer called Brocade (BRCD:Nasdaq - news) the ultimate tell of the tech tape. I'd bet that if you took a poll of investment-grade bond managers, the majority would say they had never heard of it, nor Broadcom (BRCM:Nasdaq - news), nor BroadVision (BVSN:Nasdaq - news). Companies like these, while well known to RealMoney readers, just aren't on the scope of many investment-grade bond managers.
If bond managers are underestimating the weakness in tech fundamentals and the possibility of lower inflation, I believe that presents an opportunity in bonds. There are many different ways to value bonds, one of them being to measure their yields against inflation or inflation expectations.
In the next chart, I've subtracted the Philadelphia Fed's survey of forecasters for the coming year's CPI from the yield on Moody's Baa corporates to come up with a real, or after inflation, yield. The Philly Fed survey is looking for the CPI to rise 2.48%, putting the real yield now close to 5.5%. This is near the midpoint of the past 14 years and makes bonds seem like a decent value.
Inflation Beater
The real corporate-bond yield is near 5.5%, making bonds a decent value
FRB St. Louis and Philadelphia
How do you play this as an investor? If you are worried about inflation, you can buy inflation-protected bonds because you only need inflation to rise more than 1.75% to break even on a 10-year issue vs. regular Treasury issues. If you are in the lower-inflation camp, as I am, then bonds become an even better value. The lower that you think inflation will go; the more you should want to own bonds.
At current levels, bonds look as if they will offer a pretty good real return, and I've added to my holdings of both Treasuries and corporates in the past few weeks.
If bond investors conclude that inflation will not be a problem, you could get some additional capital gains on top of your coupons. If not, then the Fed will have to become more aggressive. Without the support of bonds, it will take more Fed easings to get the job done, and it makes the tech outlook murkier. I'm reminded of the old saying that "high-short-term rates stop bull markets; low long-term rates start bull markets."
I'd still be wary of tech unless the bond market starts getting a much better tone to it. |
