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Bonds Soar on Falling Inflation Pressure


Exposure to the bond market may help investors while the labor market lags and interest rates remain low.

Although US producer prices recorded their largest increase since September 2012 in April, the Treasury market is showing signs that investors still don't fear inflation. The Labor Department said on Wednesday its producer price index rose 0.6%, beating an expected rise of 0.2%. At the start of the year, the department began using a measure that included services and construction, which has led to surprisingly volatile swings in the prices used for the figure.

Although the number shows that price pressure may be heating up, officials at the Federal Reserve continue to worry that inflation is too low. They're not necessarily concerned that deflation will ensue, but they're merely at a point of mild frustration that inflation isn't enough to support robust growth in the economy.

The chart below represents US inflation expectations by looking at the ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) over the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF). When the indicator rises, it signals that inflation pressures are increasing. The most visible move occurred at the beginning of last year, when the indicator broadly fell for six consecutive months. The move was initially due to weakening inflation data early in the year, but it further accelerated in May when then Fed Chairman Ben Bernanke hinted at ending the Fed's stimulus program. His comments sparked fear in investors that interest rates would be raised sooner than expected, which would weigh on inflation pressure.

Ultimately, the Fed didn't begin to taper its stimulus program until December of last year, and with it officials explained that benchmark rates were still a year or two from being increased. This led to a relief rally in the indicator, rising to levels that remain highs on the year. Similarly, there was another spike higher in the indicator in April due to better-than-estimated inflation readings for both producer and consumer prices. Annual producer prices almost doubled estimates, coming in at 1.4% against an expected 0.79% rise. Meanwhile, annual consumer prices rose to 1.5% against an expectation of a 1.3% rise.

The inflation expectation indicator has largely trended sideways this year, which means that increased pressure on the Federal Reserve to raise rates may not occur. The sub-2% annual inflation figure has, however, been positive for Treasury bond demand.

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Below is a chart of the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). As inflation pressures have remained tempered in 2014, this long-dated bond index has steadily trended higher. The lack of substantial price increases in the US economy, as well as the Fed's decision to leave benchmark rates low, has allowed interest rates to fall.

Early in the year, the labor market was disrupted by severe weather storms in many of the country's largest cities. This weighed on hiring, and even as we head toward summer, labor market data remains mixed. Hiring and the unemployment rate have slightly improved, but many civilians are still leaving the job market. The exodus of workers has been stated as a reason for the unemployment rate's rapid decline. Meanwhile, average jobs growth has failed to surpass 200,000 added jobs a month at any point this year, which signals corporations are still not committed to increasing the workforce.

As long as the labor market shows lackluster results and the Fed remains committed to low interest rates, inflation pressures will have difficulty increasing. This makes the case for maintaining bond market exposure in your portfolio until there's a change in the current economic narrative.

Click to enlarge

Andrew Sachais' focus is on analyzing markets with global macro-based strategies. He takes into consideration global equity, commodity, currency, and debt markets. Sachais is a graduate of Georgetown University, where he earned a degree in Economics.

Follow Andrew on Twitter: @MacroInsights
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