21 October 2021
With a sharp repricing event in the rates market over the week, we examine the potential implications for investors.
This week, the higher inflation narrative continued to gather momentum. In New Zealand, a 4.9% year on year rise in the consumer price index in the third quarter, driven by tradables, fuelled the narrative that “transitory” inflation is morphing into something more persistent. Other than the European Central Bank (ECB), which has struggled to generate inflation expectations for some time, supply bottlenecks and rising energy prices continue to be a tailwind for inflation and there is little sign in leading indicators of bottlenecks starting to reverse. US car auction prices have made new highs this month and there are risks of even higher energy prices over the winter. The continuing period of well-above-target inflation has shifted inflation expectations higher everywhere. We are conscious of more persistent inflationary pressures building in some economies, most notably in the US and the UK through rising wages, and we’ve seen a de-anchoring in the front end of curves as the market has significantly repriced near-term central bank hikes.
Front-end de-anchoring took the main stage in the rates market over the week as investors lost confidence in the transitory inflation narrative. Market participants aggressively revised forecasts for near-term central bank pricing, while keeping terminal policy rates relatively unchanged. Among developed markets, the UK has made the most headlines. Over the weekend Bank of England Governor Andrew Bailey all but pre-announced a rate hike, stating that “monetary policy cannot solve supply-side problems – but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations.” Markets moved quickly to reprice the front end of the UK curve, which is now pricing in hikes for November 2021, December 2021 and February 2022. Front-end repricing also occurred in the United States and New Zealand over the week, although not as drastic as in the UK. We think front-end pricing is now more fairly valued, but we are conscious of the drastic moves in the UK and feel that investors may be overpricing near-term rate hikes. The eurozone also saw modest front-end repricing over the week. The ECB’s push back against the pricing of near-term hikes has had little effect; however, President Christine Lagarde may be more explicit at next week’s ECB meeting.
More persistent inflation themes have pushed investors to significantly reprice front-end yields
Investors continue to have a short duration bias to the US and UK as recent inflation surprises and hawkish messaging from central banks provide a tailwind for yields to slowly drift higher. Most recent surveys have shown a large clean out in US steepeners on the expectation of a more hawkish Federal Reserve. Surveys have also shown a small reduction in US and UK shorts on the back of the recent front-end repricing moves. We are cautious of the consensus shorts in the market and are keeping an eye on investor positioning.
What does this mean for fixed income investors?
With more persistent inflation pressures arising in developed markets, we believe investors should continue to monitor front-end repricing as any overpricing could present an opportunity. We are particularly aware of the sharp moves in the UK and think the UK market is now fully priced for hikes over the next six months; however, in the US, we think the rate profile is still too low. In terms of overall duration positioning we remain short duration in countries where inflation expectations appear more persistent; thus providing a backdrop for central banks to start their process of normalisation.
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