Asset managers are weighing the impact of upgraded inflation expectations on financial markets, as the Federal Reserve moves up its timeline for interest rate hikes and bond tapering.
An array of buoyant economic data from the US resulted in the Federal Reserve upgrading its inflation expectations and moving up its timeline for raising interest rates, with the first hikes now expected in 2023.
The Federal Reserve now predicts that inflation will climb to 3.4 per cent this year. This is a marked shift in tone from the FOMC’s meeting in March, which projected 2.4 per cent yearly inflation, and no rise in interest rates until 2024.
Earlier this month, Russell Investments found that 70 per cent of fixed income managers expect inflation in the next year will exceed 2 per cent. Meanwhile, average allocations to bonds are currently at a three-year low, according to Bank of America’s fund manager survey in June.
US 10-year Treasury yields rose to 1.55 per cent on Friday, twelve basis points higher than the end of last week.
BlackRock Investment Institute sees the Federal Reserve’s new guidance as “more balanced”, with two interest rate hikes projected for 2023. “We view this upgrade as the Fed catching up with the restart dynamics.”
Last month, the rate of annual US inflation hit a 13-year high of 5 per cent. The Federal Reserve chair, Jerome Powell, said that “inflation could turn out to be higher and more persistent than we expect”.
“While the upgrade largely reflects the incoming data since the last meeting, there is a notable change: The Fed now sees the ongoing inflation surge as contributing to achieving its objective as opposed to focusing on its transitory nature,” writes the research arm of the world’s largest asset manager.
BlackRock says that the Fed’s new outlook implies a “more muted response to rising inflation than in the past.”
It writes: “Even with the upgrade, their latest average inflation projection for the next three years only just sits at the bottom of the range of what could be argued to amount to a defendable make-up for past inflation undershoots.”
Some market participants have taken the Fed’s shift as evidence that it is already retreating from its new framework, and are preparing for further tightening.
“Markets are getting ahead of themselves by baking in three rate increases by the end of 2023, as indicated by the pricing of futures tied to the cost of overnight borrowing, in our view,” write the researchers.
“We believe there is a limit to how much more hawkish the Fed can be given its inflation projections relative to the catch-up rates range,” BlackRock continues.
BlueBay Asset Management’s CIO Mark Dowding says that suggestions the Fed is disregarding previous guidance that it will allow higher inflation are “wide of the mark”.
“Yes – a somewhat more hawkish Fed equals a flatter curve and a more dovish Fed means a steeper curve. Yet talk that growth is slowing or policy has become too restrictive just seems like fake news to our ears,” says Dowding.
The US central bank has also signalled that it is now discussing tapering its bond purchasing programme, which runs at USD120 billion a month.
BlueBay expects the Fed to announce a tapering of its bond buying in September, after discussions at the August Jackson Hole meeting. “This is contingent on stronger jobs and inflation data in the interim,” notes Dowding.
He continues: “We believe that gains should be made on both fronts, with some in the market set to be surprised that inflation has yet to peak and may start to look much less transitory.”
BlackRock Investment Institute comments: “We would not view taper discussions as a signal that the liftoff is getting closer, yet there is a risk such discussions could trigger market volatility or be miscommunicated by the Fed.”
Recently, the US central bank has been accused of mixed messaging. Jerome Powell attempted to calm markets this week, by saying before a House of Representatives panel: “We will not raise interest rates pre-emptively because we fear the possible onset of inflation.”
BlackRock writes: “We believe the Fed’s new outlook will not translate into significantly higher policy rates any time soon.”
This, combined with a powerful restart, cements the asset manager’s pro-risk stance. “Large cash balances held by investors and no obvious signs of financial vulnerabilities give us additional confidence. We prefer to take risk in equities and remain underweight bonds on valuations.”
American asset manager Nuveen, which manages USD1.2 trillion, writes that the Fed’s vigilance on inflation suggests that “government bonds are undervalued”.
Nuveen writes in a recent note that US Treasury yields rose on the short end of the curve and decreased on the long end last week.
“As improvement continues, the Fed will become increasingly vigilant about fighting inflation, resulting in a rally in long Treasury bonds. The fact that the Fed will become vigilant on inflation suggests that government bonds are undervalued,” write Nuveen’s CIO of global fixed income, Anders S Persson, and head of municipals, John V. Miller.
“As a result, investors increased Treasury purchases. Municipal bonds may benefit from the Fed signalling it will be tough on inflation.”
Meanwhile, Neuberger Berman weighed the outcome for investment grade corporate and sovereign bonds.
Brad Tank, chief investment officer for fixed income says the “very nature” of these investments has been changed by the Fed’s asset purchases.
“Volatility in general has been suppressed by central bank interventions over the past decade, but that of investment grade has collapsed over the past year, while risk-asset volatility has responded more to the recovery in economic conditions,” says Tank.
Lower volatility has led multi-asset portfolio models to recommend higher and higher allocations to bonds. “Remember, this is a feedback loop. The lower volatility falls, the more modelled allocations increase, the more assets are allocated at the margins, and the lower volatility falls again,” he says.
Tank concludes: “It is difficult for us to see what can break this loop beyond an explicit statement by the Fed that it will no longer buy corporate bonds (which seems unlikely, given the disruption it might cause) or the central bank losing control over inflation.
“Should last week’s change of tone put some of those inflation concerns to rest, it may extend the current regime of extremely low volatility in investment grade and force asset allocators to revisit their models.”
