SaxoStrats has changed its outlook from non-recession to stagflation light. However, what does it imply for bond investors?
With stagflation, economists refer to a period when the economy slows but doesn't enter into a full-blown recession while inflation remains persistently high. Such a scenario implies that the Federal Reserve won't be able to hike interest rates aggressively to fight inflation as it did during the past year. Still, it will need more basis to cut rates as it did not enter a recession. Within such a scenario, it's most likely to see rates trading rangebound until a recession or a recovery set the direction.
As Steen Jakobsen explains, the outcome will be an imperceptible quasi- “Yield Curve Control” monetary policy as it will not want rates to rise too much, but even not to drop drastically. That creates the perfect environment for real money to build on their bond portfolio, taking advantage of multi-year high yields.
Stagflation: which investment makes sense?
(1) Front-end inflation-linked bonds. It’s the ultimate stagflation play. With the Fed unable to hike or cut too much, the nominal component of inflation-linked bonds will be anchored. However, their principal will increase together with inflation, and investors will receive a fixed rate of interest every six months based on the adjusted principal of the bond until it matures. Although the securities' coupon will indeed fall as inflation decreases, it’s important to note that when the TIPS matures, you will get the increased amount if the principal is higher than the original amount. If the principal is equal to or lower than the original amount, you get the original amount. Also, TIPS will benefit from potential interest rate cuts.
To understand how these securities behave in one's portfolio is helpful to compare TIPS total returns with those of nominal bonds. In 2021 and 2022, the convenience of holding short-dated TIPS versus Treasury has been staggering. While 1-to-5-year US Treasuries tumbled by -5.5% in 2022, TIPS lost only -2.7%. The reason for such outperformance lies in the inflation component, which creates a buffer against high inflation. However, TIPS do not provide a hedge against interest rate hikes, hence explaining the loss.