14 October 2021
The inflation heatwave
With inflation chatter growing louder across markets, we examine the underlying drivers and what this could mean for central bank policy in the medium term.
Fundamentals
Recent economic data prints suggest that bond markets will need to contend with inflation “running hot” for longer than initially anticipated. In the US, September’s headline consumer price index came in at 5.4% year on year, matching the largest annual gain since 2008. In addition, inflation forecasts at the most recent Federal Open Market Committee meeting were revised up, with the median forecast expecting inflation to stay above 2% through the end of 2024. While many of the factors pushing up inflation reflect “transitory” supply-side shocks (such as hiring difficulties, commodity price spikes, semiconductor shortages and transportation availability), the sheer number of headwinds suggest that higher inflation may persist. Central banks have become increasingly concerned that persistent inflation may eventually feed through to wage demands and inflation expectations. While the headline jobs number in the latest US monthly non-farm payrolls report disappointed at 194k, the miss was mitigated by a 169k upward revision in payroll gains for the prior two months, and a decline in the unemployment rate from 5.2% to 4.8%. As such, we believe the Federal Reserve (the Fed) will announce tapering at its November meeting, with bond purchases to be wound down over the next nine months, opening the possibility for a rate hike in mid 2022. Similarly, the Bank of England (BoE) has announced a clear acceleration in its response to surging UK labour costs and strong employment growth, raising the possibility of a lift-off in UK rates prior to a reduction in the pace of asset purchases. In contrast, the European Central Bank (ECB) has remained sanguine, with chief economist Philip Lane suggesting that the ECB will look through transient inflationary factors. This is despite supply chain disruptions forecasted to last well into 2022, as well as concerns over rising natural gas prices as headline inflation rose to 3.4% year on year in September, and inflation expectations remained ahead of the ECB’s targets.
Quantitative valuations
Nervous chatter surrounding inflation has pushed government bond yields higher this month, with 10-year benchmark yields rising 9 basis points (bps) to 1.58% in the US, 8bps to -0.11% in Germany and 7bps to 1.09% in the UK. Continued above-trend growth and the Fed’s well telegraphed tapering announcement support US Treasury yields moving towards our six-month forward target of 1.5%-2.0%, particularly given that the market is only pricing in a 0.4 percentage point rate increase in the US despite inflation exceeding the Fed’s target. In contrast, the market expects rate increases of more than 0.8 percentage points in the UK and Canada. In the eurozone, the market is currently pricing in only 10bps of hikes by the end of 2022 despite the ECB’s attempts to temper inflation expectations.
Inflation forecasts in excess of central bank targets have led to a divergence in the market’s pricing of rate hikes
Source: Bloomberg; data as of 11 October 2021.
Technicals
As we pass the peak in central bank accommodation, investors have generally increased their short duration bias to the US, UK and core eurozone rates – an important technical factor in recent rate moves. Moreover, the Fed and the BoE will be buying fewer government bonds having cleared the way for tapering, with the BoE being the first major G10 central bank to end its pandemic-era quantitative easing programme. In contrast, the ECB will probably still be purchasing bonds until at least the end of next year, albeit at a slower pace. As a result, we anticipate yields in the US and UK to rise faster than their eurozone counterparts.
What does this mean for fixed income investors?
As the narrative of supply pressures, inflation and more hawkish central banks continues, we believe investors should monitor short duration positioning, with particular underweights to markets where normalisation begins sooner rather than later. We favour tactical cross-market positioning, such as preferring German Bunds to US Treasuries, given the divergence in policy between the eurozone and the US in response to inflation.
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
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