Summary - Inflation is a key focus for investors, meaning uncertainty over what happens to interest rates. Yield curves have stabilised but it is not clear that renewed inflation concerns automatically mean steeper curves, especially in the US where a lot has already been done. The next phase could be curve flattening, especially if markets more aggressively price in early monetary tightening. Curve flattening needn’t be bad – the forward markets already have it priced in. But there is a malign scenario of flatter curves amid higher yields, meaning a significant tightening of financial conditions. That is an outlier for now and the central banks continue to hold fast on their tightening timetables. The next few months of inflation data will tell us which is the most likely yield curve scenario for the next two years.
Higher inflation is here
Inflation printed higher everywhere in April. It is likely that headline year-over-year inflation rates will be above most central banks’ targets in the coming months. That will give some legitimacy to the idea that central banks are behind the curve and should start removing accommodation sooner rather than later. When this argument played out earlier this year it lead to a rise in global bond yields and steeper yield curves. Central banks responded with a firm “niet” to the question of whether they were reviewing their stance. A few months later and the market has the data and could be poised for another assault on rate expectations. A broad concern in markets is that long-term yields rise again, threatening fixed income returns, credit spreads and earnings expectations. My colleagues in the Rosenberg equity team have done research suggesting another leg steeper in the slope of the US yield curve will mean that value and quality continue to outperform growth and momentum.
Still a debate
Investors need to closely watch the month on month changes in consumer prices. It’s one thing that the year-over-year rate rises considering the depressed level of prices a year ago, when the world economy was first locked down. It’s another thing when the month to month increases are well above recent averages. Core consumer prices rose by 0.9% in the US in April and by 0.6% in the Eurozone and the UK. Those fighting the inflation corner will point to these higher monthly inflation rates to argue that we have entered a new regime of inflation dynamics, with expectations rising in the household sector and company’s referencing higher input prices in earnings reports and in communications with investors. In the other camp the argument will be that much of this is frictional, related to temporary supply and demand imbalances and that existing output gaps and entrenched behaviour will limit the longer-term inflation.
Rising break-even inflation rates in the US Treasury market have been responsible for much of the steepening in the US yield curve so far. The spread between 10-year and 2-year Treasury yields has risen from zero to 148 basis points (bps) in the last two years. Judged against previous big cyclical yield curve steepening periods, there is potentially another 100bp or so to go. Could we see Treasury yields at 2.60% with the Fed still on hold? It’s possible if the momentum of economic re-opening and higher headline inflation rates is maintained. If there is a second leg it should support value equities over growth and relative stability in credit markets.
It is important to note that in previous yield curve steepening cycles, the Fed has been cutting rates. Most of the recent steepening has come with the Fed on hold. From here there are three scenarios. The first is that longer-term rates rise another 100bp with the Fed on hold and short-term rate expectations well anchored. The second is that the whole level of yields moves higher with the tightening cycle brought forward. The third is that the yield curve flattens as monetary tightening becomes more realistic.
Cant’ rely on the benign scenario
The first scenario is relatively benign but a bit fanciful. It is unlikely that markets would take long-term yields higher by another 100bp without more aggressive expectations of Fed tightening. Indeed, if markets are pricing in higher growth and inflation, then surely higher policy rates have to be priced in sooner than the timeline suggested by the Fed. The second scenario is possible but probably damaging for risk assets as it would represent a genuine tightening of financial conditions. However, is it more likely than the first. The third scenario is the one we need to focus on with a 1-2 year view. The market will front-run the Fed in terms of pricing in higher rates if the macro scenario is higher inflation and above trend growth. The worst case is that curve flattening happens with higher rates across the curve
The last economic expansion was unusually long and unusual in that it was marked by a policy of financial repression. It took seven years for the Fed to raise rates. During that time the yield curve was relatively volatile but the trend was for it to flatten (from 284bp in 2010 to zero in 2019). By its own timeline, the Fed has acknowledged this cycle will be shorter. The forward market has got it right – the curve is priced to have fallen to a 10yr-2yr spread of 62 basis points in three years’ time. The strategies that should be considered then are long duration in fixed income against an underweight position in short-dated bonds, paying fixed and receiving floating in the swaps markets (essentially a curve flattener), probably looking for wider credit spreads or increased dispersion in credit markets as the cycle matures, and an outperformance of quality growth in equity markets.
Nothing is certain in this world but investors are worried about inflation and the consequences for interest rates. Compared to previous cycles, central banks won much more of the outstanding amounts of government debt. There continues to be demand for long-dated high quality fixed income assets from pension funds and insurance companies. Together this might limit how much further bond yields can go while we can make the argument that when the Fed and other central banks do start to move back to a neutral interest rate, that could be a move of the magnitude of 1%-2%. Ahead of that happening, cyclicality will dominate, credit will continue to outperform rates and equities should benefit from the strong momentum in earnings growth. But looking forward, we will hit mid-cycle and monetary policy will be tightened. That will change market dynamics.
We always live in times of economic policy experimentation. The next few years pose challenges to central banks. The risk of fiscal dominance potentially constrains independence at a time when central bankers know they should be trying to reduce the pace of balance sheet growth and restore interest rates to levels that don’t create distortions in resource allocation. High levels of debt and the existence of what some call “zombie companies” complicate the situation. I have always had the view that, in contrast to a lot of the economics I learned, the real world is characterised by moving from one disequilibrium to another. The paths between them are unpredictable. That’s why markets do what they do, try to allocate capital based on trying to second guess those pathways. The signposts today are either higher inflation, higher interest rates or a continuation of financial repression and fiscal dominance with, as yet, unknown repercussions for financial stability and broader questions of equality.
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