(Bloomberg) — Just as bond traders grow more assured that inflation is finally under control, a camp of investors is quietly building up protection against the risk of a future spike in prices.
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These fund managers are amassing positions that would cushion fixed-income returns in the event of an inflation shock. Wall Street strategists are also recommending taking advantage of declines in market-based gauges of future inflation to build up protection on the cheap.
It’s not a consensus trade. After all, a growing batch of data, including benign inflation readings out of the US and UK, suggests that pricing pressures are easing after years of monetary tightening by global central banks. Interest-rate cuts are now in the cards and recession has replaced inflation as the dominant concern. This promising news has sent benchmark bond yields sharply lower — but perhaps too far, say some.
“We think fear of recession is overdone, but that inflation risks are possibly underpriced at current yield levels,” said John Bilton, head of multi-asset strategy at J.P. Morgan Asset Management. Bilton said he remains “broadly neutral” on duration, or exposure to interest-rate risk, given that there are “a handful of forces that could push inflation higher.”
While price growth has eased markedly from Covid-era highs, the path lower has been bumpy, and inflation in some areas has proved tenacious. The US economy remains resilient, as seen by strong retail sales figures for July, while an array of threats from US-China trade tensions and shipping disruptions to heavy public spending and turmoil in the Middle East only add to inflation risks.
For all these reasons, some investors see the need for insurance.
“If inflation proves to be stickier or goes up again, that could derail your portfolio if you’ve got exposure to duration,” said Marie-Anne Allier, who runs a €5.6 billion ($6.2 billion) fixed-income portfolio at Carmignac.
Allier thinks the market has grown overly optimistic about the inflation outlook. As an offset, she has implemented hedges via three- and five-year derivatives tied to euro and US inflation, as well as three-year Spanish inflation-linked bonds.
Central bankers around the world are also stressing the need for vigilance, even as they shift their attention toward growth risks and signal rate cuts ahead. Investors will look for clues on how the Fed is managing that balance when Chair Jerome Powell and others speak at next week’s central bank symposium in Jackson Hole, Wyoming.
“The focus from central banks was very much on inflation the last two or three years, now they’re going to pivot and focus a little bit more on the labor market,” said Neil Sutherland, portfolio manager at Schroder Investment Management. “I’m not saying that the war on inflation is over,” he added, but “they’ve done a pretty good job on that front.”
Still, many investors think inflation gauges have fallen too far. Take the US five-year breakeven rate, the difference between inflation-linked and nominal yields of similar maturities and a proxy for the average rate of price rises over the period. It fell sharply in recent weeks as recession fears flared and is now trading around 2% for the first time since the start of 2021.
A near-term crunch point could come soon after the US presidential election should it result in a win for Republican Donald Trump. He is campaigning on a platform of tax cuts, tariff increases and immigration crackdowns — all of which are potentially inflationary.
Gareth Hill, a fund manager at Royal London Asset Management Ltd., has been adding US inflation exposure to his portfolios via five-year breakevens — essentially a bet that Treasury Inflation-Protected Securities (TIPS) will outperform five-year nominal bonds. Election aside, Hill still sees value in the trade, arguing that “the last mile in the battle against inflation is the hardest one.”
Outside the US, price data from many developed countries is still proving tough to quell. Australia recently all but ruled out a rate cut in the next six months with inflation still at 3.8%, while euro-area inflation unexpectedly quickened in July. Barclays Plc strategists recommend positioning for higher euro-area inflation within the next year via short-dated swaps.
Even Japan, which finally emerged from decades of deflation, is worrying investors. Roger Hallam, global head of rates at Vanguard, says the firm is cautious both on Japanese bonds and gilts in the UK — where core inflation is still at 3.3%.
Higher Forever
Longer term, structural shifts in the global economy to address challenges like climate change and aging populations, as well as rising government deficits, mean that inflation — and interest rates — may settle into a higher range.
Amelie Derambure, a portfolio manager at Amundi SA, is already positioning for that outlook via long-dated TIPS.
“The market is right to play on the disinflation momentum in the short term,” she said. “It’s more the medium to long term that is heavily questionable.”
Citigroup Inc. recently initiated a long in US 10-year breakevens just above 2.10%, around where they were on Friday. The strategists expect longer-term inflation expectations to rise as the Fed starts easing.
What Bloomberg’s strategists say…
“Now is probably not the time take the higher-yields view, but there is a non-negligible chance – not discounted by the market at all – that inflation will begin rising again, limiting the amount the Fed can cut and disappointing the expectations for rate reductions priced in by the market and thus supportive for yields.”
— Simon White, macro strategist
For many, inflation isn’t the thing to worry about now. Eva Sun-Wai at M&G Investments for instance, says that with US core goods prices possibly already in deflation, there’s a greater risk central banks keep policy tight for too long.
Others see longer-term inflation as a risk, but warn against buying hedges prematurely given they could cheapen further. Erik Weisman, chief economist and a portfolio manager at MFS Investment Management, reckons US breakevens could narrow as much as 100 basis points if a so-called hard landing materializes.
It’s a risk also flagged by Martin van Vliet, a global macro fixed income strategist at Robeco. He’s considering closing a trade that’s profited from the decline in the 30-year euro inflation swap from around 2.80% last September to 2.30% now.
There’s also a latent vein of scepticism over just how much protection inflation-linked bonds really offer after the notes suffered heavy losses as prices soared in 2022.
But Fidelity International’s Tim Foster says the securities have proved their long-term worth. He points to data that shows TIPS across one to 10-year maturities have outperformed their nominal counterparts in 17 of the last 25 calendar years and are on track to do so again in 2024.
“More often than not, markets fail to price in upside inflation risks; there is much more likely to be a miss far above expectations than a miss far below expectations,” he said. “If investors are growing complacent about inflation, it wouldn’t be the first time.”
What to Watch
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Economic data:
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Aug. 19: Leading index
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Aug. 20: Philadelphia Fed non-manufacturing index
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Aug. 21: MBA mortgage applications; BLS preliminary annual payrolls revision
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Aug. 22: Chicago Fed national activity index; jobless claims; S&P Global US manufacturing, services and composite PMIs; existing home sales; Kansas City Fed manufacturing index
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Aug. 23: Bloomberg US economic survey; new home sales
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Fed calendar:
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Aug. 19: Fed Governor Christopher Waller
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Aug. 20: Atlanta Fed President Raphael Bostic; Fed Vice Chair for Supervision Michael Barr
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Aug. 21: Federal Open Market Committee minutes from July meeting
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Aug. 22: Kansas City Fed annual symposium in Jackson Hole, Wyoming
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Aug. 23: Chair Jerome Powell speaks at Jackson Hole
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Auction calendar:
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Aug. 19: 13-, 26-week bills
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Aug. 20: 42-day cash management bills
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Aug. 21: 17-week bills; 20-year bonds
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Aug. 22: 4-, 8-week bills; 30-year Treasury Inflation Protected Securities
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–With assistance from Ruth Carson and Michael Mackenzie.
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