This is an extract from our Q2 fixed income outlook
Disinflationary forces are set to weaken
According to the latest available data, those for March, headline consumer price inflation jumped to 2.6% year-on-year, marking the highest rate in 2 ½ years. Besides the increase in energy prices, the continued rise in shelter costs stood out. While some have dismissed this as an outlier, we believe that rents are likely to recover, supported by the reopening of the services sector, rising incomes, firming housing prices, and the need for larger spaces more suitable for working from home.
The weakness in shelter costs had been a major contributor to the decline in services inflation over the last few months. If rents do indeed recover, a significant disinflationary force will be removed.
Base effects will cause year-on-year inflation to rise further in April before it recedes again. As locked-down sectors reopen, temporary supply bottlenecks will appear in goods and services such as semi-conductors, cars, transport and leisure & hospitality – areas where inventories are already low.
Higher commodity prices as well as ‘prices paid’ readings from purchasing managers’ surveys indicate rising input prices. These may be passed through to output prices. On the labour costs side, the bounce-back in employment is likely to limit any downward pressure on wages. Indeed, some industries are even facing a shortage of qualified workers.
The cost of supply lagging demand
Looking beyond the next few months, we wonder whether the rapidly closing output gap could mean that the economy runs into supply constraints into 2022. With the administration focused on tackling inequality and the Fed seeking an inclusive recovery that will lift wages across the workforce, the unemployment rate could be pushed to low enough levels to trigger wage gains.
Companies in the US, but also in the EU, can be expected to try and make their supply chains more robust and more local, partly in response to the pandemic and partly due to the ongoing trade tensions between the US and China. In addition to the fiscal stimulus flowing into the US economy in the coming months, we could see the Philips curve slope upwards again before long.
It is not clear to us whether these factors will overwhelm the structural disinflationary impact of technology, but the odds of a significant and persistent inflation overshoot have risen.
What does this mean for Treasury and inflation protection markets?
The Fed’s average inflation framework should ensure that monetary policy remains accommodative. The Fed will likely keep policy rates on hold until at least 2023, anchoring the front end of the Treasury bond curve.
A rapid return to full employment and faster economic growth as a result of the aggressive fiscal stimulus could end the Fed’s asset purchases sooner than expected and raise longer-dated inflation-adjusted (real) yields. We believe the Fed could taper its asset purchases in early or mid-2022.
The Fed will likely tolerate increases in longer-dated real yields that do not tighten financial conditions in a broader sense. Calibrating the point at which the Fed is tipped into action is difficult, but we estimate that the 5 year-5 year real yield sustainably above 0.75% would impact other asset markets (i.e., equities). At the time of writing, the yield was around 0.35%.
With core inflation likely to overshoot the Fed’s target in 2023 as employment pushes up against the labour market’s limits, investors can be expected to continue to buy inflation protection and push 10-year break-even inflation (BEI) wider.
Finally, while we expect a somewhat higher issuance of Treasury bonds due to the Biden administration's fiscal plans, the impact of the additional supply on real yields should be limited.
There are various reasons for this view:
- The spending will be largely paid from the Treasury’s existing cash balance.
- The Fed will continue to buy much of the net supply – it has been adding USD 960 billion of Treasuries a year to its balance sheet.
- We believe the Fed would react to an increase in real yields that threatened the recovery and/or equity markets.
Instead of supply, we think the bigger concern for duration positions is that the Fed may taper its asset purchases earlier if the economy returns to full employment faster.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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