Goldman Sticking to Inflation Call Even as Price Outlook Tumbles

  • Bank sees oil impact on U.S. consumer prices as temporary
  • Value in intermediate and long-dated U.S. TIPS: Goldman

Inflation bulls are sticking to their guns.

Just when about every consumer-price indicator is saying inflation is close to dead, Goldman Sachs Group Inc. stands by its view that investors should buy long-dated U.S. inflation-protected bonds.

The U.S. investment bank, the top earner among its peers in fixed income, currencies and commodities trading as a percentage of revenue, says falling oil prices will have only a temporary effect on U.S. inflation expectations and they will rebound in the April-June period. Any spill-over impact from an economic slowdown and currency devaluation in China will be limited outside of that country, Goldman Sachs says.

The view was echoed by Stephen Jen, founder of hedge fund SLJ Macro Partners LLP, who maintains his call that upside surprises in U.S. inflation remain one of major risks for financial markets this year.

“We have not changed our fundamental view that 2016 will be a reflationary year,” wrote Goldman Sachs strategist Silvia Ardagna in a client note this week. “Our economists forecast that core CPI and wage growth will accelerate as the U.S. output gap closes.”

Break-even Trade

The bank may have jumped the gun on its call. It recommended the trade on inflation-protected bonds on Nov. 10 on the view that the market was underpricing consumer-price pressures in the U.S., particularly on the medium- and long-term horizon.

When Goldman Sachs suggested the trade, the U.S. 10-year break-even rate, a market gauge of inflation expectations derived from yield difference between nominal and index-linked bonds, was around 1.60 percent. Since then, oil prices have fallen by more than 30 percent, dragging the U.S. break-even rate below the 1.40 percent level at which the bank recommended ending the trade, and on down to 1.35 percent by Wednesday, the least since April 2009.

Other gauges also painted a similar picture. The market’s five-year estimate for inflation beginning five years from now, a model the Federal Reserve uses in setting rates, dropped to a record low 1.53 percent on Jan. 15 in data going back to 1999. On a global basis, a breakeven rate was at 0.96 percent, the lowest since September 2010, according to a Bank of America Merrill Lynch index.

Commodities Slump

The cost of living in the U.S. dropped in December, led by a slump in commodities that’s roiling global markets. The consumer-price index declined 0.1 percent after being little changed in November, a Labor Department report showed Wednesday.

Deepening concern about global growth and falling oil prices are major drivers of a decline in inflation expectations. Chinese economic growth slowed to 6.9 percent last year, the weakest since at least 1990.

The nation’s shift away from exports and manufacturing, a slowdown in emerging markets and the Fed’s gradual exit from ultra-low interest rates has prompted the International Monetary Fund to cut its outlook for world growth. The Washington-based lender said on Tuesday it predicts the global economy will expand 3.4 percent this year and 3.6 percent in 2017.

Still, according to Goldman Sachs’s analysis, medium- and long-term U.S. inflation swaps, another market metric of inflation expectations, are still underpriced relative to “fair value.”

Attraction of TIPS

Treasury Inflation Protected Securities, known as TIPS, are unlike their nominal peers in that they appreciate along with the cost of living. Even so, some investors buy the linkers for reasons unrelated to inflation, such as for their relative valuation.

Italian index-linked bonds, for example, were among top performers back in 2012 even as the euro region was in recession. Their demand was driven by cheapness relative to bonds that offered no inflation protection on a so-called asset-swap basis.

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