Vanguard leaders discuss the outlook for interest rates and inflation.
Tim Buckley: I want to pivot to what we call the rate side of things, where we think interest rates are going, looking forward. If we think about central bank policy, I don’t know how to describe it. I mean, the adjectives you hear people throw all around. You hear “unprecedented,” you hear that all the time. You could say “significant,” “monumental.” You could use them all together.
What we’ve seen from the Fed, well, pretty incredible. What we’ve seen on the fiscal stimulus side of things, well, you could say the same. What does that mean for rates going forward? What does that mean for inflation? How do you guys think about it in your fixed income team?
John Hollyer: Yes, we’re thinking a lot about rates and these important monetary policy points you made, which are happening in the U.S. and around the globe. And to boil it down we’d say, “low for longer.” Rates are likely to maintain a low level for an extended period of time, and we’re structuring our strategies around that.
If we look at things like inflation, currently markets are looking at big drops in oil prices and big drops in demand and economic activity, and taking a view that inflation will decline. Markets are pricing in, over 10 years, about a 1% rate of inflation per year, and in near-term projections of one or two years, actually projecting deflation.
In working with our economics team and trying to have a longer-term outlook, we feel like those estimates are probably understating where inflation is likely to wind up. Near term, there are plenty of hurdles, but longer-term, the fiscal and monetary policy stimulus you’re talking about is potentially going to sow the seeds for inflation to move back up towards the Fed’s 2% target or higher. So looking at that, we are gradually building positions to have exposure to inflation-indexed bonds that we think, in the long term, have the opportunity to outperform.
Tim: Now, John, that’s different than what people are used to. So, most of our clients are used to hearing, well, loose monetary policy and a lot of fiscal spending, expect inflation. But there’s just way too much flack in the economy to see that happen. You don’t see it happening years out. And so you’re saying, what you can get in the TIPS [Treasury Inflation Protected Securities] market? Those are great trades for you right now.
John: Yes, we feel like there’s some value there. And again, going with our diversified approach, the strategies in our government funds, we’re investing in TIPS. But we’re also looking at other areas where there could be outperformance—in mortgage-backed securities, for example. We see that the big drop in rates is likely to give homeowners opportunities to refinance their mortgages. That’s a problem for mortgage-backed securities. But what we’re finding is there are parts of the mortgage market where that prepayment by homeowners is mispriced and is creating some opportunity that we feel can yield to positive excess returns above expectations for our clients. So it’s an area where we’re trying to, again, diversify our strategies.