Even as bond traders grow more confident that inflation will eventually be brought under control, a group of investors is quietly building protection against the risk of future price spikes.
Some fund managers are accumulating positions to cushion fixed-income returns in the event of an inflation shock, and Wall Street strategists are also suggesting taking advantage of market hedges against forecasts of lower future inflation to build protection positions on the cheap.
This is not a consensus trade. After all, a growing body of data, including benign inflation readings from the U.S. and U.K., suggests that price pressures are easing after years of monetary tightening by central banks around the world, that recession has replaced inflation as the main concern, and that rate cuts are a foregone conclusion. The hopeful news has sent benchmark bond yields sharply lower. But some believe the market may have gone too far.
"At current yield levels, we believe recession concerns are overblown and inflation risks are likely underestimated," said John Bilton, head of multi-asset strategy at JPMorgan Asset Management. Bilton said he maintains a "broadly neutral" stance on interest rate exposure given "a number of forces that could push inflation higher."
While inflation has slowed significantly from its pandemic peak, the path down has been bumpy and inflation is proving stubborn in some areas.
The U.S. economy remains resilient, as shown by strong retail sales data in July, while a range of threats, from international trade tensions and shipping disruptions to huge public spending and unrest in the Middle East, only increase upside risks to inflation.
For these reasons, some investors believe it is necessary to take measures to counter a potential rebound in inflation.
“If inflation proves to be more firm or rises again, it could destabilize your portfolio if you have interest rate exposure,” said Marie-Anne Allier, who manages a 5.6 billion euro ($6.2 billion) fixed-income portfolio at Carmignac.
Allier agrees that the market is too optimistic about the inflation outlook. To offset this, she hedges with three- and five-year derivatives tied to euro and U.S. inflation, as well as three-year Spanish inflation-linked bonds.
Central bankers around the world are also stressing the need to remain vigilant even as they shift their focus to growth risks and signal rate cuts. Investors will be looking for clues on how central banks are handling the balance between inflation and growth from speeches by Federal Reserve Chairman Jerome Powell and others at a central bank symposium in Jackson Hole, Wyoming, this week.
“Central banks have been focused on inflation for the last two or three years and now they’re going to turn to the labor market and pay more attention to it,” said Neil Sutherland, a portfolio manager at Schroder Investment Management. “I’m not saying the battle against inflation is over, but they’ve done a pretty good job of that,” he added.
Still, many investors believe that the market's inflation indicators have fallen too far. Take the break-even rate of five-year U.S. Treasury Inflation-Protected Securities (TIPS), for example. In recent weeks, as concerns about a recession have grown, this rate has fallen sharply and is currently around 2%, the first time since 2021 (see the figure below). It refers to the difference between the TIPS yield and the nominal yield of similar maturities, and is also an alternative indicator of the average price increase during this period.
The near-term crisis could come soon if Republican candidate Donald Trump wins the U.S. presidential election on a platform of tax cuts, tariff increases and a crackdown on immigration, all of which have the potential to stoke inflation.
Gareth Hill, a fund manager at Royal London Asset Management Ltd., has been adding U.S. inflation exposure to his portfolio through five-year TIPS breakevens, essentially betting that five-year TIPS will outperform nominal bonds of similar maturities.
Election aside, Hill still sees value in the trade, arguing that "the last mile in the fight against inflation is the hardest."
Outside the U.S., inflation data in many developed countries remains difficult to calm. Australia recently all but ruled out a rate cut in the next six months, with inflation still at 3.8%, while eurozone inflation unexpectedly accelerated in July. Barclays strategists recommend positioning for higher eurozone inflation next year through short-term swaps.
Even Japan, which has finally escaped decades of deflation, is worrying investors. Roger Hallam, Vanguard’s global head of rates, said the firm is cautious on both Japanese and U.K. government bonds because core inflation in the U.K. is still running at 3.3%.
Inflation and interest rates will be higher in the long run
In the longer term, structural changes in the global economy to respond to challenges such as climate change and aging populations, as well as rising government deficits, mean that inflation and interest rates are likely to move into a higher range.
Amelie Derambure, a portfolio manager at Amundi SA, is already preparing for that prospect with long-term TIPS.
“Markets are right to take advantage of the disinflationary momentum in the short term. More questionable are the medium- to long-term trends,” she said.
Citigroup strategists expect long-term inflation expectations to rise as the Federal Reserve begins to ease.
“It may not be time to take a higher yield view yet, but there is a possibility that inflation will start to pick up, limiting the Fed’s rate cuts and undercutting the rate cuts that the market is pricing in, which will support yields,” said Simon White, a Bloomberg macro strategist. “The market is simply not realizing this.”
For many, it's not inflation to worry about right now. For example, Eva Sun-Wai of M&G Investments said that core U.S. commodity prices may have already fallen into deflation, and the risk is greater that the Fed will keep policy tight for a long time.
Others see long-term inflation as a risk but warn against hedging too soon given the potential for further cost reductions. Erik Weisman, chief economist and portfolio manager at MFS Investment Management, believes the breakeven point for U.S. TIPS could shrink by as much as 100 basis points in the event of a so-called hard landing.
The risk was also noted by Martin van Vliet, global macro fixed-income strategist at Robeco, who is considering closing a trade that profited from a fall in 30-year euro inflation swaps from around 2.80 percent last September to 2.30 percent now.
There are also underlying doubts about how much protection TIPS actually provide after their yields plunged in 2022 as prices soared.
But Fidelity International's Tim Foster says the security has proven its value over the long term, pointing to data showing that 1- to 10-year TIPS have outperformed their nominal counterparts in 17 of the past 25 calendar years and are expected to do so again in 2024 (see chart below).
“Markets have often failed to factor in upside risks to inflation, with misses well above expectations more likely than misses well below expectations,” he said. “If investors have become increasingly complacent about inflation, this would not be the first time.”
Article forwarded from: Jinshi Data
