21 January 2021
Higher inflation looks set to be on the cards in the coming months. While the risk of a taper tantrum-like scenario can't be discounted entirely, we see a gradual rise in yields as the more likely outcome.
The Covid-19 crisis should act as a disinflationary force, given the amount of slack it has created in the economy, but several factors are likely to drive inflation higher over the next couple of months. Base effects, owing to the sharp fall in inflation last spring, could push year-on-year inflation measures higher: US headline consumer price index (CPI) inflation is projected to rise to around 3% in April/May, from 1.4% currently. The combination of pent-up consumer demand plus potential supply bottlenecks as economies reopen may drive up services inflation, likely around the same time as the base effects come into play. For this temporary bounce in inflation to become more entrenched, shelter (housing cost) inflation would need to improve from its current weak levels, given the large weighting of this component in the overall CPI basket (about 30%). Shelter inflation is cyclical but slow-moving, so a rise is entirely possible as lockdowns are lifted and the labour market improves – but it is unlikely to be steep. Importantly, much of our view of higher near-term inflation is contingent on the economic reopening, so it will be necessary to look out for hurdles to the vaccine rollout, such as any decline in the efficacy level when only single doses have been administered.
Pent-up consumer demand could drive up services inflation
The inflation drivers have been well telegraphed, though the extent of the temporary rise may be underappreciated so there is scope for the market to overreact and push bond yields higher. Importantly, higher yields in and of themselves don’t spell the end of fixed income – rather, it’s the speed at which yields rise. For instance, a taper tantrum-like scenario in which yields pushed materially higher in a short span of time would pose a meaningful challenge to bond markets. While this is a risk factor to monitor, we do not expect it to occur given that the inflation rise should be transitory and recent Federal Reserve commentary has been dovish, reiterating the central bank’s commitment to its average inflation targeting regime. In our view, 10-year US Treasury yields have reached the local high and are likely to trade in a narrow range in the near term, but to push higher at a measured pace over the course of the year, heading towards 1.5% to 2% as the vaccines take effect, economies reopen and further fiscal stimulus is implemented.
If history is a guide to the technical implications of a taper tantrum-like scenario, the risk is significant outflows, particularly from risk markets that are sensitive to rising rates, such as emerging markets debt. For now, this appears to be a low-probability event as the wall of cash continues to underpin bond markets: compared to the run-up to the taper tantrum in the spring of 2013, assets in money market funds are currently more than 2.5 times higher at USD 3.6 trillion. Given the rising rate environment we anticipate – measured in pace, driven by an improving economic backdrop and a temporary bounce in inflation – it is reasonable to anticipate ongoing demand for fixed income spread sectors. (Data as of 19 January 2021.)
What does this mean for fixed income investors?
Investors are largely in agreement on the direction of the economy and the implications for market moves – but it’s imperative to regularly challenge ourselves on that consensus view. As we dig into what could disrupt our expectation for a gradual and tempered move higher in bond yields, inflation is one possibility. There could be scope for tactical duration trading around forthcoming inflation prints, as the market may overreact to the higher reports even though base effects have been flagged. That said, we believe that the temporary nature of the rise in inflation and the accommodative stance of the Federal Reserve will result in a grind, rather than a spike, higher in yields.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum