Inflation is “still underpriced” in financial markets, says BlackRock

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Markets are “still underestimating” the potential for above-target inflation, according to a recent note from BlackRock Investment Institute.

“We believe markets are still underestimating the potential for above-target inflation over the medium term. As a result we prefer inflation-linked bonds and are underweight nominal government bonds over the strategic horizon,” writes the asset manager’s research arm. 

Concern over rising inflation has come to a head in recent months, with a record 93 per cent of investors in April expecting higher global inflation in the next year, according to a survey by Bank of America.

These fears are driving an ongoing sell-off in the market for nominal government bonds, which began in the first quarter of 2021. 

Investors are instead pouring money into US Treasury Inflation-Protected Securities (TIPS), which offer protection against a potential decline in purchasing power from rising inflation. Data from EPFR shows that USD14.4 billion flowed into TIPS funds in the year to the middle of April. 

BlackRock recently closed its tactical overweight position in inflation-protected bonds. “We have closed our tactical overweight in inflation-linked bonds as inflation expectations have risen sharply, but favour them strategically as we see medium-term inflation still underpriced,” writes the firm.

In nominal government bonds, BlackRock remains underweight following a sharp rise in 10-Year Treasury yields, with the expectation that short-term rates will “stay anchored near zero”.

The Federal Reserve has announced its intention to let the post-pandemic economy run hot before it raises interest rates. Chairman Jerome Powell has said he will allow inflation to run above the 2 per cent target for "some time".

US inflation has already risen in response to successful vaccination roll-outs, fiscal stimulus, and the restart in economic activity. 

Consumer prices rose 0.6 per cent month-on-month in March, pushing up the annual rate of inflation to 2.6 per cent, rising from 1.7 per cent the month before.

“Inflation looks set to overshoot the Fed’s target as we have expected. Yet we see uncertainties around the near-term persistence of the overshoot as the restart leads to unusual supply and demand dynamics,” writes BlackRock.

Global supply chains have faced constraints during the pandemic such as component shortages, rising raw material prices and longer delivery times. 

Meanwhile, pent-up demand will be unleashed as virus restrictions ease and activity reopens, which BlackRock believes “could lead to volatile inflation in the near term”. 

“We see US CPI inflation averaging just under 3 per cent between 2025-2030, and we believe this is still underpriced by markets. First, we expect higher production costs as the pandemic accelerates the rewiring of global supply chains. Second, major central banks are evolving their policy frameworks and explicitly intend to let inflation overshoot their targets. Third, the higher debt levels will make it harder for central banks to lean against inflation – and make the decision to start tightening more politicised, in our view,” concludes BlackRock.

However, not all investors are convinced that inflation will be here to stay.

The Federal Reserve’s intention not to act to contain inflation is a “positive development” and rising Treasury yields “signals the health of the economy”, according to Lazard Asset Management. 

Lazard Asset Management’s US Fixed Income team writes: “The key questions are how high inflation might rise and whether inflation expectations might be de-anchored. We expect inflation of between 2 per cent and 3 per cent in 2021 and 2022. However, we do not believe one or two years of elevated inflation is sufficient to de-anchor expectations.” 

A common signal of inflation expectations is the ‘breakeven rate’, which is the difference between the yield on the 10-year US Treasury and the 10-year TIPS. 

The breakeven rate jumped to 2.30 per cent in March 2021, having jumped from 0.50 per cent one year before. “This implies that markets expect inflation to be 2.30 per cent a year, on average, over the next 10 years,” writes Lazard. 

The firm disagrees with the market view, instead expecting that higher inflation will be “transitory”.

“Importantly, although inflation is likely to be higher in the near term, it will likely be on account of base effects or easy comparisons versus the corresponding year-ago period, and viewed as transitory. Markets also are not indicating a sustained inflationary environment, as the recent rate rise has been marked by an increase in real interest rates and term premiums, not higher expected inflation,” writes the asset manager.

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