Expert analyses implications of inflation outlook, recession risks, and Fed moves
Last year’s extreme rate hikes have brought pain across the investment universe, with long-duration bonds suffering some of the worst drawdowns. But as inflation figures start to cool and central banks edging away from their aggressively hawkish moves, is it time for investors to wade back into the longer end of the yield curve?
“Growth is clearly weak enough to allow output gaps to ease the pressures on capacity that were worrying central banks, and indeed to ease inflation,” said Robin Marshall, director of Fixed income research at FTSE Russell, in a recent webinar.
Based on private-sector GDP consensus forecasts, Marshall said Canada’s real economy is projected to grow by only 0.7% this year. Based on the IMF’s forecasts for the G7 economies, which were updated in April, advanced markets are generally just escaping recession, with some signs of a pickup in the services sector.
Inflation: a shock or a new regime?
While there’s been evidence of a cyclical peak in inflation in North America – with Canadian and U.S. CPI figures falling significantly from their summer 2022 zeniths of 8% and 9%, respectively – he also noted a marked divergence in inflation among the G7.
“That’s pretty unusual in the last 10 years,” he said. “That may be evidence of deglobalization.”
A critical question for investors, he said, is whether the inflation picture that developed starting in 2021 until now represents a structural change or a one-off shock. A return to the higher-inflation regime of the ‘70s and ‘80s, he said, would pose a risk to asset-allocation models like the 60-40 portfolio.
“Higher interest rates to control inflation … will [have an] impact across the board [on] financial assets. We saw that last year,” he said, noting how central bank tightening crushed assets, particularly those with long duration. “Even inflation hedges didn’t do well in that environment.”
Looking at major market and macro indicators, he said most of the evidence points to a protracted shock. Across all major markets except Japan, there’s been a full inversion in the yield curves covering ten-year to two-years. Inflation breakevens – calculated by taking the difference between real yields and nominal yields – have fallen after a post-Ukraine invasion spike in the first quarter last year.
“There’s been a decline in inflation expectations of breakevens since then,” Marshall said, citing the severe policy tightening by G7 central banks as a powerful contributor. “The Bank of Canada has done over 400 basis points of tightening [since last year]. The Fed’s done 500.”
Fed tightening creates economic tail risks
While inflation is now declining rather quickly, major economies are also not far from recession with negative growth in real wages across the G7. And while the broad consensus in markets is for a soft landing, Marshall said there’s still a substantial tail risk that central bank tightening, particularly the Fed, has been too much too late.
“The banking woes in the US regional banks, I think, confirm that that's where the balance of risks lies,” he said. “When you bear in mind how much tightening [the Fed has] done, and the changes in the regulatory standards in the US with banks of less than with less than 250 billion in assets not stress-tested, it’s perhaps almost surprising that there wasn't a major problem in in a regional bank that came to light before March of this year.”
With the development of modern fintech and information technology, Marshall cautioned, bank runs can erupt much more quickly than they have historically. The fact that over 40% of U.S. bank deposits are uninsured only accentuates that risk.
While SVB, Signature Bank and First Republic owned less than 3% of total U.S. bank assets, their collapse has had broad ramifications. Regional banks have started to tighten their lending, Marshall said, and loans to commercial real estate investors were quite concentrated in the small banking sector. The upshot, he suggested, is that the Fed might cap its tightening at the 5% level as it seeks to avoid applying any more pressure on the economy.
“Flexible inflation targeting, gives the BoC plenty of leeway to leave rates where they are for a while,” he said, noting that the BoC’s early action puts it in a better position to take a pause than other central banks. “They’re forecasting inflation at 3% by mid-year … and back at target in 2024.”
Following the “death by duration” in fixed income in H1 2022, when the long end of the yield curve took a heavy pounding, Marshall said yields have stabilized and pulled back from their highs. Still, they remain elevated in the post-GFC context with short yields not far below 4% and longer government yields at around 3%. That means even if the BoC doesn’t move to ease rates quickly, the market still looks comparatively cheap.
With the flat-to-inverted profile in Canadian bonds, he said investors today won’t get much reward for taking on extra duration risk. But taking on more duration might be worth it, he said, when the reinvestment risk outlook is added to the equation.
“If the Bank of Canada starts to move towards easing and the policy pause extends, the market will front run that and yields will drop faster,” he said, noting that short bond yields drop faster than those on the long end. “The duration effect in the longer yields will give you a stronger return. … You can make a case for saying it is time to dip into the water again, and to own a little more duration.”