Inflation Was a Bad Bet Last Year

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Inflation Was a Bad Bet Last Year

Investors entered 2018 expecting strong economic growth to fuel inflation. A year later, they’re still waiting for higher consumer prices.

Despite early-year concerns about rising prices that hurt demand for bonds, Treasury debt indexed to the rate of inflation returned less than conventional U.S. government debt in 2018. That’s because inflation hasn’t taken flight, even with wages rising at the fastest pace in almost a decade and unemployment near a 50-year low.

Total returns for Treasury inflation-protected securities slumped in the fourth quarter to end 2018 down 1.4%, counting price changes and interest payments, while those for fixed-rate U.S. government debt climbed 1.9%, according to Bloomberg Barclays data. The negative returns in TIPS marked a reversal from earlier in the year, as mounting concerns about the pressures weighing on global economic growth cut into inflation expectations.

Owning TIPS “has been a bit of a painful trade,” said Donald Ellenberger, head of multiasset strategies at Federated Investors, which holds the debt. “Even though inflation has turned lower, the Fed is just going to go on raising rates.”

While faster inflation poses a threat to the purchasing power of a conventional bond’s fixed interest and principal payments, it typically leads to increased demand for inflation-indexed debt. Holders of TIPS receive a small yield as well as an increase in their principal equal to the annual change in the consumer-price index.

As expectations for inflation have declined, fixed-coupon government debt has become more attractive. Trade tensions and tightening financial conditions have also spurred stock swings and gains in the U.S. dollar, denting investors’ appetite for risk and expectations for growth and reducing appetite for inflation-protected bonds. A long fall in oil prices has also weighed on expectations for inflation, because oil prices comprise a large component of the consumer-price index.

“Inflation expectations aren’t going to pick up if oil prices are in decline,” said Frances Donald, chief of macroeconomic strategy at Manulife Asset Management. She said she’s recommending long-term fixed-coupon Treasury debt, which perform well when inflation remains low, to Manulife’s portfolio managers.

The Federal Reserve’s December decision to raise interest rates and to pencil in two more increases for 2019 is likely to keep inflation expectations lower, analysts and investors said. The bond market’s measure of inflation expectations has fallen to an average of about 1.7% over the next 10 years from a 2.2% average in early October.

The consumer-price index rose 2.8% in May from the prior year, according to the Labor Department, the fastest pace since 2012. Since then, however, it has moderated, slipping to 2.2% in November.

Long-term Treasury debt rallied after the Fed’s decision, with the 30-year-bond yield retreating below 3% for the first time since August. Shares of utilities—known as bond proxies because they tend to pay high dividends—have been a relative bright spot for investors in recent months.

Policy makers have been “obstinate” in their belief that plentiful employment opportunities will lead to more inflation, said Joseph LaVorgna, chief economist for the Americas at Natixis. Instead, the decision to raise interest rates will likely lead to slower growth and inflation.

“This is going to prove to be a policy mistake,” he said.

The decline in inflation expectations has been mirrored by a swing in investors’ expectations for the path of interest-rate policy. Signs of weakening economic data, combined with lower oil prices and increased volatility in the stock market, have sapped expectations for prices to accelerate in 2019.

Fed-funds futures, which investors use to bet on the direction of Fed rates, show a 53% probability that officials will cut rates by the end of 2019 and 47% odds that rates end the year at current levels, according to CME Group data. That contrasts with futures bets in November which pegged the odds that rates would be higher than they are now at 90%.

That could be a boon for TIPS investors in coming months since interest-rate cuts and other forms of looser monetary policy typically promote inflation.

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Write to Daniel Kruger at Daniel.Kruger@wsj.com

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