Some of the world’s biggest bond investors say the market is wrong to expect central banks to score a long-term win in the war against inflation.
There’s little doubt that interest-rate hikes from policy makers in the US and Europe will pull consumer-price increases down from the fastest pace in decades by slowing economic growth or setting off recessions.
But the retreat of inflation from its peak isn’t likely to mark a return to the price stability of the recent past because of stark shifts in the world economy, according to a broad group of investors and strategists at firms including Pacific Investment Management Co., Capital Group and Union Investment.
During the period of expanding globalization, cheap commodities and low labor costs helped keep inflation at bay. Now, that’s starting to reverse. Oil and gas prices are elevated as nations sever ties with Russia over the Ukraine war. Businesses are weighing political tensions while rebuilding frayed supply chains. And tight labor markets are giving workers the power to push for higher pay.
That has money managers who oversee trillions of dollars bracing for inflation to hold well above the roughly 2% level targeted by major central banks. To guard against that risk, they have been buying inflation-protected bonds, boosting exposure to commodities and expanding cash holdings instead of plowing it directly into bonds, wagering that consumer-price increases won’t quickly pull back to levels seen in recent decades.
“The last twenty years of the great moderation — that’s fully behind us now,” said Tiffany Wilding, North American economist at Pimco, which had about $1.8 trillion under management at the end of June. She anticipates a period of highly volatile inflation as the world adjusts to changes that will “lead to higher input costs in general that should result in a multi-year price level adjustment.”
The views contrast with speculation that price pressures will ease so much that the Federal Reserve may start cutting interest rates next year to jump-start economic growth. While benchmark 10-year Treasury yields have risen recently to push slightly over 3%, that’s still nearly half a percentage point below the mid-June peak. And a bond-market proxy of US inflation expectations over the next two years has been cut nearly in half since March to about 2.7%, not all that far above the 1.9% average increase in a broad price gauge in the 20 years before the pandemic.
Both policy makers and markets have been surprised by how stubbornly high inflation has been, since it was initially thought to be a temporary side effect of the pandemic that would fade once economies reopened. On Wednesday, the UK reported that consumer prices increased at a faster-than-expected pace of 10.1% in July, the most since 1982. That surprised traders, who dumped 2-year government bonds, triggering a steep jump in yields.
“The view in the market that central banks will be in a position to cut rates in a number of countries will be challenged in due course,” Ivailo Vesselinov, chief strategist at Emso Asset Management, who expects the yields on slightly longer dated bonds to jump as the realization that inflation will be more persistent sinks in.
No one expects current levels of inflation to last, making the debate about whether it has crested yet or not beside the point. The key question is what economies are facing over the next three to five years, when many investors are expecting repeated flare-ups in price pressures akin those during the geopolitical turmoil of the 1970s.
Among the major reasons is the expectation that trade tensions, high energy prices and a tight labor market that’s putting upward pressure on wages may not dissipate soon. In Europe, the challenge is all the greater given the region’s dependence on Russian energy supplies, while the ECB also has to keep in mind the implications of monetary policy for 19 disparate economies.
Still, while policy makers across geographies have repeatedly emphasized that they will keep tightening policy until inflation is contained, it’s possible they could pivot in the face of a deep slowdown. Fed officials acknowledged there was a risk that they could tighten more than necessary to restore price stability in the minutes of the July 26-27 meeting.
Union Investment’s Michael Herzum, the head of macro and strategy, sees a risk that the Fed will stop hiking rates prematurely, only to start doing so again once inflation roars back.
“Looking at growth and not just inflation is a very risky game because the structural trend we had since the mid-1980s — the disinflationary trend — is turning,” he said.
Flavio Carpenzano, investment director at Capital Group in London, said tight labor markets worldwide mean that the Fed has to induce a large recession and a higher unemployment rate to get inflation to go down sharply.
His team seized on the July rally to cut holdings of US debt most sensitive to interest-rate hikes and see China as attractive from a fixed-income perspective because inflation there is less of a concern.
“We see the slowdown in inflation occurring at a much slower pace than what the market is expecting,” said Carpenzano, whose firm managed some $2.7 trillion at the end of last year. He said the market is off in pricing that the Fed will cut rates in mid-2023. “Inflation is by no means a solved puzzle and the Fed will continue to be vigilant.”
Another factor: companies are weighing increased political tensions as they rebuild supply chains roiled by the pandemic. That may weaken the power of a long-running disinflationary force: the moving of jobs to low-wage countries. In the US, President Joe Biden signed a $52 billion measure to spur semiconductor manufacturing in the country. His Treasury Secretary, Janet Yellen, has also promoted the concept of “friend-shoring,” or diversifying supply chains among allied countries to protect against disruption.
“It will take years to rebuild the trade networks and supply chains,” said Glen Capelo, managing director at Mischler Financial.
“Deglobalization is here to stay,” he said. “This will all be inflationary. And this structural inflation is something the Fed can’t fight with higher rates.”
