Wall Street is preparing for a possible resurgence in inflation as President Donald Trump prepares to enter his second term.
Investors are faced with a complex landscape, which includes rising inflation expectations, soaring stock prices, and uncertainty tied to Trump’s agenda, such as taxes, tariffs and immigration.
The rising long-term bond rates suggest that markets are pricing a growing US economy under Trump, but also anticipating an increased US debt load, increased Treasury issuance, as well as inflationary pressures.
The Treasury Inflation Protected Securities (TIPS), once hailed as a hedge against the inflation, have fallen out-of-favor.
TIPS are not popular among investors despite metrics that point to inflation risks. This is due to lingering skepticism resulting from past losses in periods of rising interest rate.
The Treasury will auction securities maturing in ten years worth $17 billion on Thursday to gauge the demand for TIPS.
This issuance will be a litmus-test to see if investors are willing to embrace TIPS again in the face a renewed inflation risk.
TIPS: A Shadow of Their Promise
TIPS was introduced in the 1990s to help investors navigate inflation.
Their performance during the Federal Reserve’s historic rate increases exposed vulnerabilities, especially for longer-duration bond.
TIPS holders suffered steep losses as a result of the 2022 bond market crash, which soured investor sentiment.
The rapid ascent in real rates from negative territory crushed the TIPS prices and led to a mass exodus of this asset class.
Investors are still reluctant to revisit TIPS, despite persistent inflation risk.
Rodney Sullivan of the Mayo Center for Asset Management of the University of Virginia noted in a MarketWatch article that many investors hadn’t returned since the 2022 selling-off.
“Inflation is not yet defeated,” he said. But investor confidence in TIPS was shaken.
TIPS face structural challenges despite their initial appeal. Will Compernolle said in the report that thin trading volumes make TIPS vulnerable to volatility.
He said that even small changes in market flows could cause large changes in TIPS yields. This further complicates their appeal.
New TIPS can also distort the market readings. Compernolle explained that the big drop on August 3 was due to the fact that it was the first day of business after the new TIPS auction for the 10-year period was settled. It was not because people had changed their estimations of inflation in the next decade.
These nuances, along with rising benchmark Treasury yields, and mortgage rates approaching 7%, reflect broader concerns about inflation, even though TIPS remain underutilized.
Are stocks the new hedges against inflation?
While TIPS are no longer popular, stocks are becoming a viable alternative.
The Dow and Russell 2000 have seen smaller gains than the S&P 500.
Nasdaq’s 26% rise underscores robust performance in the tech sector, further bolstered through consumer spending resilience.
Kourkafas said that stocks have been performing well as a hedge in recent times. “Assets that can keep up with inflation are needed to protect against inflation.”
This trend reflects the shift in investor strategy, with market participants preferring equities to bonds.
Market enthusiasm is strong despite the Federal Reserve’s caution, as investors expect growth-friendly policies from Trump.
How real is the inflation fear?
The rising long-term bond rates suggest that markets are pricing a growing US economy under Trump, but also anticipating an increased US debt load, increased Treasury issuance, as well as inflationary pressures.
Tom Barkin, President of the Richmond Fed, said to the Financial Times that US inflation was susceptible to shocks.
He said that businesses were “concerned”, about the inflationary effect of the sweeping tariffs, and plans to deport the illegal immigrants, which Trump had touted during the campaign.
Barkin said that he could understand why businesses believe that, but that other Trump policies relating to boosting the domestic energy production might be “disinflationary”.
The Federal Reserve is taking a cautious approach. The October consumer-price indicator revealed a rise in inflation of 2.6% annually. This was the first increase in 7 months.
Fed Chair Jerome Powell assured the markets that he would not resign, if Trump asked him to do so. This added stability to the monetary policy discussion.
Powell expects the inflation rate to be between 2% and 3% in 2019. This will allow for modest rate reductions.
Angelo Kourkafas is senior investment strategist for Edward Jones.
“But not as much as in the past three years.” Kourkafas cited corporate pricing power as a hedging strategy, as businesses pass higher costs on to consumers, boosting stocks as an inflation resistant asset.
This post Inflation worries grip Wall Street but TIPS struggle with investors – Here’s Why may be modified based on new developments.
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