Cedric, the last month has been eventful in bond markets – how have you navigated recent developments?
Yes, in mid-May we held the view that US breakeven inflation (BEI) rates would continue to rise. This view was based on the following arguments:
- Core inflation pressures would continue to build gently in the coming months, taking the core inflation rate above target
- The year-over-year headline inflation rate would head towards 3.0% by the July print (released in August), largely due to base effects
- Financial conditions would remain accommodative, with the US Federal Reserve (Fed) continuing to raise rates by more than priced in by the market, but by less than would be required to fully offset the stimulus from the administration’s fiscal package
- The Federal Open Market Committee (FOMC) would emphasise its tolerance of an inflation overshoot, stressing the symmetry of the inflation target
- We considered there was a possibility that the FOMC would, in the next few months, discuss potential changes to the monetary policy framework, with the Fed possibly looking to adopt a price-level path targeting approach to fulfilling its inflation objective
- Evidence of ongoing allocations to the US Treasury inflation-protected securities (TIPS) asset class.
Given our baseline scenario that the FOMC will deliver more rate increases than is priced into the overnight indexed swap (OIS) curve, we also maintained a nominal curve flattening exposure.
From a technical perspective, we nevertheless recognised that 2.25% was an important technical resistance level for 10-year US BEI rates, and that a catalyst would likely be required to push 01/2028 BEIs through and above that level to a target of 2.40%. That catalyst would ideally be stronger wage data and/or core consumer price index (CPI) data.
And what risks did you see to your view that breakeven inflation rates could rise further?
We identified several possible scenarios with the potential to jeopardise our view that BEI rates would rise:
- The FOMC could turn more hawkish and signal its intent to offset the fiscal stimulus through an accelerated path for rate increases
- Oil prices could suddenly pull back
- The US administration could escalate confrontation with the EU, China and NAFTA partners on trade policy
- A populist coalition might successfully form a government in Italy.
The primary downside risks to our long BEI position was clearly that the formation of an Italian government from a coalition of 5-Star and League would trigger a market stress episode, on concerns about the fiscal implications and the possible consequences for the eurozone.
And how do you view prospects for BEI rates now that investors’ concerns about Italy have somewhat receded?
Investor concerns on Italy have at least temporarily receded somewhat following assurances by Italian finance minister Tria and European Affairs minister Savona that the Italian administration has no plans to exit the eurozone.
Nevertheless, we remain concerned that the administration will, in due course, put forward fiscal proposals that breach European Union budget deficit rules, initiating a confrontation with the European Commission, and validating investor concerns over the Italian Treasury’s long-term fiscal sustainability. In other words, we continue to see an obvious inconsistency between assurances that Italy will avoid measures that might lead to an exit from the eurozone and its stated fiscal agenda. Rome’s budget proposals will likely be delivered to Brussels in September or early October, so we anticipate market stress could well return as policy details emerge. For the time being, however, soothing words and net redemptions on outstanding Italian government debt are likely to keep yields of Italian sovereign bonds contained.
The risks of a trade conflict have also been a source of concern for investors in recent weeks. How do you see these influencing inflation-linked bond markets?
In early June we were treated to a display of Trump-style US diplomacy at the G7 meetings in Quebec. The US administration’s refusal to sign the communiqué and its treatment of its EU and NAFTA partners have significantly raised the odds of an escalation of trade conflict, with US tariffs being met with retaliatory measures. Furthermore, recent press reports suggest the administration will proceed with proposals to apply tariffs to Chinese goods, which will, again, be met with swift retaliatory measures. If enacted, these tariffs would likely be supportive for short-dated BEIs and could be supportive for sovereign bond markets via the adverse impact on growth and economic confidence.
And finally, the FOMC meeting on 13 June was a significant one – what is your analysis of its outcome?
This meeting of the FOMC provided some revelations that clarify the Fed’s intentions:
- The FOMC’s median projections confirmed that four hikes are likely in 2018
- The median ‘dots’ showed the FOMC would reach the 3.4% peak rate projection earlier, since a hike was added to the end-2019 projection
- Chairman Powell clarified in the press conference that inflation ‘symmetry’ referred to a tolerance for a temporary over or undershoot of inflation versus the target. He noted that persistent deviations from the target would not be countenanced, and that “price-level path targeting is not something the Committee has looked at seriously, and not something that is on the calendar right now”. This was a clear confirmation that speculation about a possible change to the FOMC’s policy framework is premature.
In my view, the implications of the June FOMC meeting are as follows:
- The FOMC looks set to continue raising rates at a steady, gradual pace (i.e. once a quarter), in both 2018 and 2019. Rates are likely to peak at around 3.50% at some point in 2020, but we note that OIS curves suggest a peak rate at around 2.70%, suggesting an opportunity to be underweight nominal duration in the 2-year to 5-year sector
- The rejection of price-level path targeting suggests inflation will not be allowed to significantly and persistently deviate too far above target. This weakens the argument for long BEI positions based on the thesis of a permissive monetary policy regime. It also weakens the case for positions anticipating a steepening of the nominal Treasury curve. If inflation is to remain close to target, and the FOMC is hawkish, then investors are better advised to remain in nominal curve flatteners.
So, overall, what conclusions do you draw for inflation-linked bonds from events over the last month?
Here’s what I take away from what’s happened:
- The FOMC’s relatively hawkish June meeting argues for flatter Treasury curves, rising yields in short-dated Treasuries, and a flat BEI curve. Chairman Powell’s initial rejection of price-level path targeting as a potential innovation for the policy framework is also not encouraging for long-dated BEIs.
- The risks of a trade war have clearly risen since mid-May, and concerns are also much higher about the risks of a renewed flare-up in Italy’s debt sustainability. As a result, a flight to US Treasuries cannot be excluded – so a small overweight in US sovereign debt makes sense although it does not square with the more hawkish take I have on the FOMC.
US core CPI inflation data for May was disappointing, even though recent average hourly earnings numbers were more robust. This means we are still waiting for a catalyst for further BEI widening.
The renewed potential for tariffs, along with a more hawkish FOMC, means there is more scope for a rise in short-dated BEIs than long-dated BEIs.