Fund managers mull higher inflation after “major uplift” in US growth forecasts
At a meeting of the FOMC last week, the Federal Reserve upgraded its forecasts for US growth and left its accommodative monetary policy unchanged, prompting a resurgence in inflation concerns from investors.
Yields on US 10-year Treasuries broke 1.7 per cent last week, sliding back slightly on Monday. The US government bond market has had a turbulent year so far, after a sell-off in February driven by investors' fears of higher inflation.
In March, a Bank of America survey of fund managers revealed that higher-than-expected inflation is now considered the biggest threat to markets, followed by a “tantrum” in the fixed income market as investors sell bonds.
The majority of fund managers have been cutting their Treasuries allocations to underweight in recent months, pruning back their positions after a bumper year of investment in safe-haven fixed income assets.
Last week, officials at the Federal Reserve said they now anticipate the US economy will grow by 6.5 per cent this year, as vaccine roll-outs encourage a pick-up in the labour market and consumer spending rises.
Despite this backdrop, monetary policy will be kept on hold with interest rates remaining near zero until at least 2024, and the Fed says it would tolerate inflation rising above its target of 2 per cent. The central bank also plans to continue its bond buying scheme at a rate of USD120 billion per month.
“While bond markets can take comfort from the Fed delivering on its promise to go slowly with rate hikes, despite inflation creeping above the 2 per cent target, the monetary tide is nevertheless turning,” says Paul O’Connor, head of Multi-Asset at Janus Henderson Investors.
O’Connor believes the central bank’s mettle will be tested if the US economic recovery accelerates into the summer and the pressure to tighten monetary policy intensifies. “The big debates have been deferred not decided.”
“Many of the questions that have been avoided today will linger over the months ahead and may well have become more urgent by the June FOMC. By then, the Fed might be prepared to take the first decisive step away from the current super-accommodative monetary stance by indicating when it will start to taper QE.”
O’Connor notes that the consensus in favour of rock-bottom interest rates and asset purchases is already weakening. “Whereas, back in December, only five of 18 Fed officials predicted higher rates in 2023, seven now expect a rate hike in that year and a third of the committee expects that more than one will be needed. Four participants now project hikes for 2022, compared to just one in December.”
Kempen Capital Management is maintaining a negative outlook on government bonds, with the US bond market showing the “biggest risk of further yield increases”.
Joost van Leenders, senior investment strategist at Kempen, believes that “inflationary pressure is too weak and monetary policy too robust” to give way to a sharp rise in the near future.
“The US economy is recovering rapidly and a further wave of fiscal stimulation is on its way. At 6.3 per cent, the unemployment rate is still relatively high and well above the level at which wage increases and inflation start to climb,” says van Leenders.
High levels of employment allow companies to raise their prices more easily and employees to demand higher wages, leading to inflation. The actual unemployment rate may be much higher than this, with Treasury Secretary Yellen estimating effective unemployment at 10 per cent due to many leaving the job market.
“Things can happen fast in the US. Between May and October last year, 12.6 million new jobs were created when the economy partially reopened. Unemployment dipped by nearly 8 per cent during that period,” says van Leenders.
Van Leenders also considers the possibility that the Federal Reserve may accelerate its bond buying programme in order to keep yields from rising.
“If market fears of inflation reach excessive levels and interest rates rise too quickly, central bankers will have to convert their words into deeds, creating a situation in which monetary policy is made more expansionary in order to prevent interest rates from rising further,” notes van Leenders.
In March, the ECB signalled its intention to increase bond purchases “significantly” in the next quarter. “We are not doing yield curve control,” said ECB President Christine Lagarde said at a press conference, and the central bank said the decision was taken to address a tightening of financing conditions.
Higher bond yields have also provoked concern from investors about a sell-off in risk assets, with equity markets close to all-time highs pumped up with fiscal stimulus.
“Our view is that investors should not be concerned about this – yet,” says Dickie Hodges, head of Unconstrained Fixed Income at Nomura Asset Management and Manager of the USD3.36 billion Nomura Global Dynamic Bond Fund.
Hodges says it will be “some time” before the Federal Reserve feels the need to control inflation, “particularly since they have indicated that they are willing to tolerate much higher rates of inflation than are currently discounted by bond yields”.
“Inflation expectations will rise, but inflation will take time to become truly embedded, especially through wage increases, which central banks ultimately want to see. Once inflation does force the Federal Reserve’s hand and interest rates start to rise meaningfully, investors will find it increasingly expensive to fund risk positions and equity markets in particular will most likely suffer sharp falls,” says Hodges.
For the time being, Hodges believes that steeper yield curves may actually be beneficial for some sectors of the economy, including banks, cyclical sectors of the economy, and emerging markets.
Joseph Amato, chief investment officer of Equities at Neuberger Berman, pours cold water on fears about rising bond yields, saying the current rate environment is still supportive for equities.
“Yields at 1.7 per cent-plus need not be a source of great concern. That takes us back only to where they were in summer 2019 – with 6.5 per cent growth expected in 2021 instead of the 2.2 per cent growth achieved in 2019, conditions still easy in most other financial markets, and little or no fear of any policy tightening this year,” says Amato.
“In fact, in light of these growth expectations we would be very concerned if long-term rates stayed at historically low levels. That may imply the market is highly sceptical about the economic recovery.”