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The Turning Point? How Rising Inflation Might Affect Fixed Income and Currency Exchange

Paresh Upadhyaya
calender-icon Posted on June 05, 2012


While markets are currently focused on the negative implications of a Euro breakup, causing Treasuries to rally strongly (as investors seek “safe havens”), let’s not forget that in March of this year Treasuries plummeted in value as investors grew anxious that the U.S. economy and inflation would test the Fed’s resolve to hold interest rates down. The most recent rally in Treasuries only increases our conviction that investors need to be positioning their fixed income portfolios for the return of inflation and the subsequent pressure it will exert on the yield curve. Indeed, we believe the odds are rising that the government bond market may be entering a long term bear market, based on a few key factors:

  • QE3 expectations are receding in light of stronger than expected U.S. growth, an improving trend in the labor market and most importantly, core inflation and inflation expectations rising above levels when QE2 was implemented.
  • Given the signs that the balance of risk has shifted from deflation to inflation, the markets may be underestimating how quickly the Fed may start a tightening cycle.
  • Given how low Treasury yields are, any upward bias in the yield curve will have a magnified effect on the price of Treasuries.

As a result, we believe bond portfolios should have a healthy serving of:

1) Floating rate securities

2) High yield bonds

3) Higher yielding investment grade securities

4) Emerging market sovereign and corporate debt

In a rising interest rate environment, these securities have the ability to cushion the upward migration of the treasury yield curve with spread compression or the ability to reset.

Currency Exchange (FX)

The relationship between inflation and the US Dollar (USD) is a complex one. Rising inflation does not directly lead to a stronger USD. However, if the Fed becomes concerned over inflation and responds by tightening monetary policy, that action should help strengthen the Greenback. Therefore, the relationship between inflation and the USD is at best an indirect one.

Historical analysis suggests that inflation targeting countries, such as those in the G10, may see their exchange rates appreciate in response to rising inflation, while non-inflation targeting countries (Fed and Bank of Japan – before this year), may not experience a significant impact to their exchange rate. In an interesting academic white paper, Richard Clarida and Daniel Waldman delve into more detail about these findings regarding the correlation of inflation announcements on exchange rates.  I touch on them briefly in our recent white paper, The Tug of War Between Inflation and Deflation.

The Fed has a dual mandate of price stability and full employment. A recent speech by Bernanke seems to suggest the Fed is moving closer to an inflation target. While not perfect, this could have the impact of boosting the USD on any inflation surprise.

Emerging Markets (EM) Currency

A rising inflationary environment in the U.S. will have a few consequences for EMFX. An indirect consequence from the G4 QE policies has been asset price inflation for many EM countries. If the Fed becomes concerned about inflation and begins to tighten monetary policy, the Fed will begin to remove excess liquidity from the global economy. That will prompt many EM nations to keep monetary policy on hold or possibly reverse their tightening bias. This will push interest rate differentials in favor of the USD.

Another consequence is that the decline in liquidity will put downward pressure on EM asset prices and could trigger outflows causing the local currencies to sell off against the USD.

Read more about our perspectives regarding the economy and the fixed income markets in The Tug of War Between Inflation and Deflation.

 

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