Asset classes—inflation and economic growth
Producer price inflation in June and the Atlanta Fed’s Business Inflation Expectations survey report for July, were both released on Wednesday, July 16. The reports indicated that inflation was increasing, which reinforced a trend seen in the Consumer Price Index (or CPI) and the personal consumption expenditures (or PCE) over the past three months.
The CPI report for June, which released on Tuesday, July 22, showed that prices increased 2.1% on a year-over-year (or YoY) basis. Core inflation—inflation excluding the more volatile food and energy components—came in at 1.9% on an annualized basis.
Producer price inflation increased by 0.4% month-over-month (or MoM) in June, compared to market estimates of 0.3%. Although the higher-than-expected increase was largely energy-related, producer price increases would trickle down to consumers as well. Inflation impacts both stock (IVV) and bond investments which increases the required rate of return.
Regardless of the Fed’s monetary policy stance, increases in the rate of inflation are likely to push bond yields higher for all maturities,whether or not they’re investment-grade bonds or high-yield bonds (HYG), all else equal.
The exceptions to this would be the very short-end of the yield curve. The short-end of the yield curve would be impacted more on the path and level of the Fed funds rate which has been kept artificially low, near zero levels since December, 2008, as a result of the Fed’s dovish monetary policy.
You can protect your portfolio from higher inflation by investing in commodities like oil, gold, and silver because these assets are usually a good inflation hedge. Treasury Inflation Protected Securities (or TIPS) also provide fixed income investors with an inflation hedge option. The SPDR Gold Trust ETF (GLD) and the iShares COMEX Gold Trust ETF (IAU) are two funds that track the price of gold bullion.
Impact of monetary tightening
High-yield bonds may see limited upside going forward as the economy improves and the Fed raises rates. The Fed has indicated the first rate rise in nearly six years is unlikely to come before 2015.
In this scenario, the “reach-for-yield” tendency among high-yield bond investors is likely to be curbed as investors would then be able to obtain the same yield by investing in higher-rated bonds which have lower credit risk. This may result in an increase in junk bond spreads, instead of the contraction that usually accompanies economic growth. Bond prices fall as yields increase, which would affect high-yield debt (JNK) returns.
To read about recently released economic indicators that indicate the health of the economy, please check out the Market Realist series, Economic indicators and earnings shrug off events overseas.