Higher inflation leads to repricing in rates
Expectations for official cash rate increases were pulled forward as yields jumped in October – so much so that we believe those expectations have overshot. In Australia, the cash rate path is likely to be between the RBA’s dovish commentary and the hawkish pricing of the market.
October saw extreme moves in shorter-dated bond yields as expectations for cash rate increases were pulled forward in virtually all markets. For example, the Australian three-year bond yield rose by 92bps in October as the market moved to price a cash rate of close to 2% by 2023. The proximate cause was a reacceleration in the underlying rate of inflation across many economies, and accompanying this, hawkish shifts by numerous central banks in both developed and emerging economies. The move was fuelled, no doubt, by both the extremely low cash rates from which we are starting – as well as market positioning on expectations that yields would remain low for longer.
Inflation had already bounced strongly from the lows in mid-2020. This was partly due to ‘base effects’ – we were starting from depressed levels, in particular due to the collapse in the oil price last year – and partly it was due to some outsized gains in a small number of price categories (eg, used cars in the US). However, the recent reacceleration is indicative of the impact of supply-side inflation globally. Supply issues are appearing in many different places, including:
- Labour markets, with worker mobility restricted and labour force participation having fallen due to COVID;
- Distribution systems, with bottlenecks pushing shipping freight costs up five-fold this year;
- Energy markets, particularly in Europe where Russia has restricted gas supply and in the UK where renewable energy generation was lower due to a lack of wind;
- Housing materials, since suppliers can’t keep pace with renewed demand for renovations; and
- Chip manufacturing, where among other things, a drought in Taiwan has restricted water availability to this water-intensive industry.
A common theme across many of these issues is the disruption to production and distribution owing to COVID restrictions. The ‘transitory’ case for inflation argues that once production resumes to pre-COVID levels, bottlenecks will clear and inflation will come back down. The ‘persistent’ case argues that COVID has fundamentally changed inflation dynamics, whether due to a more permanent shift in production (more localised, work from home) and demand preferences (more home demand, environmentally conscious) or due to a changed approach by policymakers. In their COVID responses, fiscal policymakers spent heavily to limit damage to employment and to support incomes with little concern for fiscal sustainability; while central bankers like the US Federal Reserve (Fed) have shifted to ‘average inflation targeting’ – meaning they will let inflation run higher than previously before responding with higher rates. Our view is that it is likely inflation will run at more elevated levels (say 2-3% versus 1-2% previously across developed economies) over the next several years as a result of the above factors, but whether inflation becomes truly ‘permanent’ at higher levels remains to be seen.
Economic activity in most countries rebounded very strongly once vaccines were rolled out and economies reopened, before more recently softening. In one sense, softer activity is a natural counterpart to the inflation story – since it is partly the inability to produce enough that is driving inflation higher. While companies appear to be maintaining profitability by passing on costs, the consumer response to higher inflation is a critical question. Some argue inflation will simply be a tax on consumption, others argue that this is an opportunity for workers to finally demand higher wages. Central bankers are therefore focusing most of their attention on labour markets.
Although short-dated bond yields rose everywhere in October, central bank responses to the inflation threat have been notably different. Among developed economies, Norway and New Zealand have already begun raising rates, while England and Canada are threatening to do so. The Fed is taking a measured approach, indicating it will taper its bond purchases first, before perhaps commencing rate hikes late next year. The RBA – having undershot its inflation target zone for years and with wage growth still anaemic – has maintained a consistent line that it won’t be raising rates until 2024.
Throughout the month the interest rate dominoes fell in one country after another – the UK, New Zealand and Canada all saw sharp daily increases in short-dated yields of 30-40bps. Australia’s turn came in the last week of the month, following a slightly stronger CPI release, with some yields moving 80bps higher in just two days. This was larger than any move seen during the GFC, or in fact any episode of bond market volatility in decades. The dislocation was exacerbated by the RBA’s admission – as evidenced by its decision to refrain from further bond purchases in order to defend its 0.1% three-year yield target – that its yield curve control (YCC) policy was now past its use-by date.
Beyond the inflation scare and the drama in short end rate markets, the other key issue for fixed income markets remains the possibility of default by some Chinese property developers, which saw Chinese high yield credit spreads widen further. Elsewhere however, corporate credit spreads were relatively unaffected, while equity markets rebounded on strong earnings results. Strong corporate profitability and continued preference for equities appear to be underpinning the positive risk sentiment, despite the volatility and move higher in yields.
Our performance was disappointing in October. Although we were short duration versus the benchmark by more than 0.50 years throughout the month, this position was predominantly held in the US where bonds outperformed other countries (despite more obvious inflation pressure and a central bank that is closer to tightening). Based on the view that Australia would outperform the US in a globally led sell-off, we were close to neutral duration in Australia for most of the month. We were also surprised by the reacceleration in global inflation – we had assessed inflation to be more persistent than markets were pricing, but had been expecting this to result in an increase in longer-dated (rather than shorter-dated) inflation expectations, as central banks delayed their response. Aligned with this, although we hold a strategic view that yield curves will flatten with the tightening cycle, we had expected the inflation shock to initially play out through steeper curves in the shorter term. Through the month we did reduce our Australian duration, increase our inflation-linked bond exposure and shifted our yield curve positioning to benefit from flattening, but these changes were not sufficient to insulate the portfolio from underperformance. Even though our duration positions contributed positively to performance, our inflation and curve positions detracted. Meanwhile, our exposure to Asian corporates – though not directly to Evergrande – was also a smaller negative contributor.
We believe that in some cases expectations for cash rate increases have now overshot. This is especially true in Australia, where the likely cash rate path is probably somewhat between the continued dovish commentary from the RBA and the very hawkish pricing by the market. We also maintain the view that Australian bonds should outperform the US. However, while the inflation pulse continues to lift globally and central banks will remain under pressure to respond, the bond market is likely to remain uncertain. In early November we have increased our Australian duration but remain short duration in the US and at the total portfolio level. We are also overweight inflation-linked bonds and have yield curve flattening positions. Our credit exposures are still modestly constructive, and mostly concentrated in high quality Australian market, while our global spread exposures include allocations to US securitised assets and Asian corporates and we have a derivative short position in US high yield.
The rates repricing has generated a better starting point for bond market returns, and some of the extreme moves have created opportunity. We do however expect more volatility in markets as uncertainty about the persistence of inflation, the impact on economic activity and the central bank response plays out. We are also monitoring closely the interaction between rates and riskier assets. We are actively managing the portfolio to provide diversification and a low-risk source of income to broader portfolios and expect these characteristics to hold true even as the environment for bonds remains challenging.
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