Nate Geraci
October 21, 2009
Imperatives wrought by emerging deflation/inflation risks
During the past year, much has been said and written about inflation risk. And more recently, there has been increased chatter regarding deflation risk as well – with some analysts discussing the two as a sequential possibility, with deflation striking first.
Nobody can say with certainty how the deflation/inflation dynamic will play or precisely when significant shifts will occur.
We can say with confidence, however, that the macro-economic environments of 2012 and 2015 will be considerably different from what we see today or the macro environment that prevailed prior to mid-2007.
The secular declines in interest and inflation rates that emerged following the 1987 crash and in the wake of the late 1980s S&L crisis have been definitively constructive to both equity and bond performance over the past twenty years. A progressively weaker dollar in the 2000s and a consumer credit bubble that got rolling in the 90s, but exploded in the 2000s, were also constructive to equities and bonds of nearly all stripes.
Looking ahead, though, expectations are generally for historically wide swings in deflation/inflation rates, interest rates, currency exchange rates and, rather generically, in risk appetites. From an investment and risk management perspective, deflationary and inflationary swings are likely to have pronounced and highly varied impacts across segments of fixed income markets. Accordingly, greater discernment between subsets of the broader fixed income asset class is likely to be of far greater importance in the coming decade than it has at any time in recent decades. If you want to find out more about exchange rates/ currencies, click here to find out more info.
For example, a severe deflationary cycle would – as Pimco’s Bill Gross recently suggested – likely be supportive of Treasuries across the maturity spectrum, but in the intermediate and long segments in particular. Corporates, though, would suffer from the flight to safety of Treasuries to an extent dependent on the scale and intensity of a deflationary turn.
A severe inflationary cycle, however, would be constructive to TIPS and short-term bonds while quite damaging to longer maturity Treasuries and corporates.
Also posing challenges to the management of bond portfolio risk is the rapidly evolving dollar relationship relative to both developed and emerging market currencies. A rapidly expanding Treasury bond supply across economies, especially those running large and protracted current account deficits such as the U.S., is an important shaper of interest and exchange rates.
And, too, the printing of money is in vogue – in the U.S. it is currently taking on the form of repurchase of Treasuries by the Federal Reserve Bank even as the issuance of Treasuries is running roughly triple the pace of a year ago. The FRB/Treasury has also become the preferred parking garage for significant volumes of mortgage and consumer debt-backed securities posted as collateral by major banks for funding at cheap short-term borrowing rates.
The need to consider staying tactically nimble in fixed income and the benefits of knowing what you have in ETFs, on a daily basis, make segmentation of the broader fixed income asset class in ETFs an important exercise for all risk managers.
Here’s a look at what most investors would need to cover every major segment of the broader fixed income asset class. There are no less than six noteworthy U.S. segments and three international segments.
US Government issues – Treasuries: SHY (1-3 Yr), IEI (3-7 Yr), IEF (7-10 Yr), TLH (10-20), TLT (20+ Yr), PLW (1-30 Yr Laddered).
US Agency issues – Mortgage backed: MBB, MBG
US Corporates: Investment-grade, LQD: High-yield, HYG, JNK
US Municipals: TFI; SHM (short-term)
US Convertibles: CWB
US TIPS: TIP; STPZ (short-term)
International developed market treasuries: BWX (local currency-denominated); BWZ (short-term; local currency-denominated)
International emerging market treasuries: PCY (dollar-denominated), EMB (dollar-denominated)
International TIPS: WIP (local currency-denominated)
Understanding performance and risk attributes of individual segments of the fixed income asset class will be far more important over the next three to five years than at any time during the past twenty years. Where a diversified aggregate bond holding might have sufficed during the secular decline in interest and inflation rates, massive performance divergences might render fixed income segmentation critical in the potentially dramatically different interest rate, inflation rate and dollar value environments going forward.
