Key strategy: Will deflation contain the bear market in bonds?

Key strategy: Will deflation contain the bear market in bonds? (Part 1 of 6)

Is the Fed losing its inflation battle? A guide for ETF investors

U.S. inflation

The below graph reflects the Federal Reserve Bank’s struggle to maintain a modest level of inflation in the U.S. economy. The Fed would prefer to keep inflation running around 2.0% per annum, providing banks and consumers the protection they need from declining asset prices. As we mentioned in the earlier articles, banks become reluctant to lend against assets that decrease in value, and the average American consumer becomes reluctant to spend when the value of their home declines.

This series takes a quick look at past and present economic growth data, government spending, interest rates, and inflation, and considers the outlook for ETF-focused fixed income investors amid a rising rate environment. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

USA Inflation Rate (CPI) 2014-02-18Enlarge Graph

Too much supply, not enough demand

The above graph would suggest that the U.S. economy suffers from an excess supply of goods and services and a lack of final demand for these goods and services. The decline in the unemployment rate is largely due to the retirement of the Baby Boomer generation and discouraged workers leaving the workforce, with the labor participation rate at ’70s-era lows of 62.8%. The decline in the unemployment rate for 2013, from 7.5% to 6.7%, has been due to many people no longer being counted in the workforce, with 548,000 leaving the workforce in the past year, according to the St. Louis Fed. Since 2010, the U.S. civilian workforce not in the workforce had grown from roughly 153.2 million to 155.8 million in 2013, with the associated loss of 2.5 million workers accounting for nearly 2.5% of the 3.3% improvement in the unemployment rate.

Supply and demand rebalance

While the decline in labor force participation due to discouragement isn’t a positive development, it is possible that the retirement of the Baby Boomer generation could improve the employment outlook for those under the age of 50, who often have more education and training in modern technology and computers than their predecessors. The continuance of this trend may mean an ongoing decline in the workforce as the elderly retire, though younger workers should be able to fill in this gap and thereby contribute to economic growth. For more research pertaining to the different types of unemployment data, including the U-1 through U-6 worker, please see the related article, Is US employment a positive or negative for stocks?

The China factor: China exports deflation

As far as the supply of goods is concerned, low-wage manufacturing work in China continues to contribute to the decline in low-end manufacturing in the USA, which has fallen from nearly 25% of the U.S. economy in 1970 to closer to 12% of the U.S. economy today. For more analysis of the impact of China’s manufacturing and trade on the U.S. and global economies, please see the related series Slowing export growth rates cull China’s equities.

For fixed income investors

For fixed income investors, deflation can contribute to lower interest rates and higher bond prices. However, should deflation persist, the economy could weaken, and lower-quality bonds could face declines due to the deterioration of credit quality. In other words, U.S. Treasuries and very-high-quality credits might remain a good investment in a very-low-inflation or deflationary environment. But if inflation reaches or exceeds 2.5% and the economy returns to a 2.5% or higher trend growth, the highest-quality bonds, including U.S. Treasury bonds, would also likely see a decline in price and a rise in yields.

To see how rising real interest rates are limiting the bear market in bonds, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related series A flagging consumer price index contains the bear market in bonds.

Outlook: High credit quality and longer duration (TLT & BND) versus lower credit quality and mid duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).

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