Deflated Inflation Expectations

© Can Stock Photo Inc. / NataliyaShirokova

We’ve written before about inflation and its corrosive effect over time. The topic has become much more timely because of two developments:

1. The prospects for inflation have gone up with the large increase in the price of oil and other forms of energy. We could potentially see annual inflation indicators top 3% within the next six months.

2. Money continues to flood into long-term low rate fixed income, as safety-seekers buy bonds yielding in the 1 and 2 percent range.

It appears these trends are in for quite a collision. Our first principle is ‘Avoid stampedes in the markets.’ So we suspect that the safety-seekers may not end up with what they were seeking. If today’s 2% bond is repriced in a 3% world, capital losses may result.

Human tendency is to expect current conditions and trends to continue. So the prospects for inflation are pretty much ‘out of sight, out of mind,’ since we have not had much inflation for quite a while. But the large increases in the price of oil and other raw materials could potentially generate annual inflation rates in excess of 3% over the next few months. Crude oil, for example, bottomed at $28 per barrel in February 2016. Current prices in the $40’s, if they persist until February 2017, will exert a lot of upward pressure on inflation.1

One would expect that investors locked in at 2% yields when inflation is running at 3% will not sit still for it. The mystery is, will the stampede of money into bonds come stampeding back out if safety-seekers find losses on their supposedly safe investments?

The potential for profit lives in the gap between expectations and unfolding reality. We believe inflation expectations and corresponding investment yields are off the mark. We have no guarantees, but our opinion is inflation will be up and bond prices will be down in the months and years ahead. If you would like to talk about the ramifications on our portfolios or yours, write or call.

1Oil prices retrieved via Federal Reserve Bank of St. Louis

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.