Obamacare Wins U.S. Bond Converts as Slowing Costs Tame CPIDaniel Kruger
Regardless of what Americans think about Obamacare, reining in health-care costs is winning the support of investors in U.S. Treasuries.
After doubling in the past two decades, medical expenses rose less last year than at any time since Harry S. Truman was president in 1949, helped by Medicare reimbursement cuts. The rollout of President Barack Obama’s signature 2010 law will hold down consumer prices for years to come as millions of Americans obtain coverage under the Patient Protection and Affordable Care Act, BNP Paribas SA and Credit Suisse Group AG said.
Less inflation, which boosts the purchasing power of fixed-rate payments, may help attract buyers to Treasuries as the economy strengthens and the Federal Reserve pares its own bond buying. While yields have fallen this year, the compensation 10-year notes provide after inflation is close to the highest in five years. Excluding food and energy, health care accounted for about a third of the slowdown in consumer prices, which rose 1.1 percent in the past year from 2 percent in the prior 12 months.
“This is good news” for bonds, Kathy Jones, a New York-based fixed-income strategist at Charles Schwab & Co., which has $2.25 trillion in client assets, said in a telephone interview on April 4. By holding costs down, “it may be a benefit to inflation, longer-term.”
Jones, who has been advising clients on the bond-market implications of the health-care law, is recommending that investors buy 10-year Treasuries because low inflation will keep the Fed from lifting interest rates.
Costs for medical care increased 2 percent last year, the smallest gain in 65 years, according to data compiled by the Labor Department. Price increases eased as Medicare reimbursements were cut under last year’s budget sequestration and Americans gained access to more generic drugs.
In the two decades before the financial crisis, health-care expenses rose at more than twice that rate on an annual basis.
The slowdown in medical expenses has helped curb inflationary pressures, with living costs rising 1.48 percent in 2013, the least during an expansion in 39 years.
“Inflation is already very low, so having one more category that lowers it even more makes nominal Treasuries even more attractive,” Aaron Kohli, an interest-rate strategist at BNP Paribas, one of 22 primary dealers that trade with the Fed, said in an April 10 telephone interview from New York.
Consumer prices in March rose 1.5 percent from a year earlier and increased 0.2 percent from the previous month, according to government data released today.
Using the Fed’s preferred gauge of inflation, known as the personal consumption expenditures deflator, or PCE, health care is having an even greater impact in containing prices.
Because medical spending accounts for 17 percent of PCE inflation as its second-largest component, slower growth in health care may delay the Fed’s eventual move to lift the benchmark rate that it has held close to zero since 2008, said Martin Hegarty, the New York-based head of inflation-linked bond portfolios at BlackRock Inc., which manages $3.86 trillion.
The slowdown in medical inflation means “PCE is going to be lower” than CPI, Hegarty said by telephone.
Inflation has remained below the Fed’s 2 percent target for 22 straight months and “a couple” of policy makers said at its March meeting that “unusually slow growth” in health-care prices has played a “notable role” in holding back prices, minutes of the gathering released on April 9 show.
February’s 1.1 percent core PCE matched January as the lowest since March 2011. Including food and energy, inflation was even weaker, eased to 0.9 percent from a year ago.
The slowdown, which has frustrated Fed Chair Janet Yellen’s efforts to lift inflation, has made Treasuries more appealing.
While forecasters predicted yields on 10-year Treasuries would rise this year to end at 3.44 percent, borrowing costs have fallen even as the Fed began curtailing its stimulus after spending more than a half-trillion dollars buying U.S. debt in
2013. Yields on the 10-year note decreased from a 29-month high of 3.05 percent in January to 2.65 percent yesterday.
They were at 2.62 percent as of 10:28 a.m. in New York.
Although that level is almost 2 percentage points below the two-decade average, they still offer returns that are close to the highest since 2009 relative to inflation. Real yields are now 1.72 percentage points higher than PCE, versus 1.21 percentage points on average in the past five years.
Some bond investors are already paring back their inflation expectations. Based on the gap between yields of fixed-rate Treasuries due in 2019 and inflation-linked notes of the same maturity, traders anticipate consumer prices will rise an average 1.84 percent annually over the next five years.
The implied rate is lower than the 2.2 percent average a year ago and less than economists’ annual projections through 2016, the furthest year available in Bloomberg surveys.
Obamacare helps to explain some of the optimism, BNP’s Kohli said. The law, which survived a 2012 challenge in the Supreme Court, represents the biggest change to the U.S. health system since Medicare and Medicaid were established as part of president Lyndon B. Johnson’s Great Society programs in 1965.
It was designed to cover at least 30 million people, by expanding Medicaid and setting up online markets where consumers can buy insurance. Parts of the Obamacare cut Medicare payouts to poor-performing hospitals, added incentives to curb readmission rates and changed payment programs to reduce unnecessarily expensive procedures.
While half of Americans oppose Obamacare and numerous computer issues with its online marketplaces stymied early sign-ups, about 7.5 million have enrolled for insurance under the law, surpassing the first-year goal of 7 million.
The CBO lowered it’s estimate for the cost of the law through 2024 by $104 billion from the previous estimate in February. The CBO and the Joint Committee on Taxation estimate the law will produce savings of more than $1 trillion over the next two decades.
That savings will mean less borrowing, putting downward pressure on Treasury yields, according to CRT Capital Group LLC in Stamford, Connecticut.
“The ACA is a very important driver” of lower prices and is helping create disinflationary expectations, Carlos Pro, New York-based interest-rate strategist at primary dealer Credit Suisse Group AG, said by telephone on April 9. Health-care costs and Obamacare have been one of the main themes of Pro’s discussions with clients since July.
Some investors may be overestimating the benefits of Obamacare on future price gains as an aging U.S. population pushes up health-care spending and costs over time, according to Michael Pond, the New York-based head of global inflation-linked research at Barclays Plc, a primary dealer.
By 2030, one in five Americans will be 65 or older, versus one in eight in 2003, and the fastest-growing segment of the population will be 85 and older, according to a report by the Department of Health and Human Services.
More immediately, downward pressure on health costs will ease this year with no repeat of sequestration, Pond said.
“Demographics were in play here, and are essentially set in stone,” he said by telephone on April 7. Any slowdown in inflation caused by health care is “temporary.”
Strengthening economic growth may also spur consumer spending. The world’s largest economy will expand 3 percent next year, the fastest rate in a decade, according to economists’ estimates compiled by Bloomberg.
That hasn’t stopped investors in exchanged-traded funds from abandoning bets on a pick-up in inflation and growth.
The $12.45 billion iShares TIPS ETF, the largest fund tracking Treasury Inflation Protected Securities, lost $423.7 million from redemptions for the month as of April 10. That erased all the net inflows accumulated in March, when the ETF’s assets rose $326.8 million, data compiled by Bloomberg show.
Invesco Ltd., which manages $230 billion, has been analyzing the health-care overhaul and predicts Treasuries will likely benefit as the law damps inflation, even as health-care spending rises as newly insured consumers seek care, said Tony Wong, a fixed-income analyst at the Atlanta-based firm.
Invesco has been adding to its holdings of longer-maturity Treasuries, according to Robert Waldner, the firm’s head of multi-sector fixed income.
“There are some structural factors that over the medium-term will exert a lot of downward pressure on health-care inflation,” Wong said by telephone on April 9.