Investors told to brace for bond tantrums and higher inflation

CIO believes CPI numbers underestimate inflation increase as worries grow that U.S. economy will overheat

Investors told to brace for bond tantrums and higher inflation

While the population scrambles to get vaccinated, markets appear to have put the pandemic in the rear-view mirror, according to one chief investment officer.

Rob Edel, of Nicola Wealth, highlighted a March Bank of America survey, which revealed fund managers no longer view COVID-19 as the biggest tail risk. Instead, they view the top two causes of anxiety as higher-than-expected inflation and a “tantrum” in the bond market.

Signs of both have been evident recently as 10-year bond yields jumped nearly 34 basis points and ended March at 1.74%, while according to the Bloomberg Barclays treasury index, bonds fell 4%, their largest monthly decline since 1980.

In addition, the Bank of Canada took a hawkish lead yesterday, with a policy right turn. It kept its benchmark rate in the lower bound but said it will pare back asset purchases and move up the timeline for potential rate hikes.

Speaking before that announcement, Edel said that while a faster-than-forecast vaccine rollout is partially responsible for increased optimism in the U.S., the massive fiscal stimulus is prompting many to worry that the economy might overheat.

After passing the $1.9 trillion “American Rescue Plan” in early March, President Joe Biden announced plans for an additional $2.25 trillion infrastructure bill, dubbed the “American Jobs Plans” last month. Biden is also widely expected to unveil an additional program, the “Caring Economy” bill, with an estimated $1 to 2 trillion price tag in the not-too-distant future.

Edel believes this creates the ideal recipe for inflation. He explained: “Official CPI numbers likely understate the increase in inflation given the basket of goods used to calculate CPI is different than the typical pandemic consumption basket. Consumption patterns have changed and inflation is higher than reported. Brace yourself, however, inflation is likely to get a whole lot higher.”

The Federal Reserve, however, is sticking with the company line that inflation will increase but the impact will be transitory. Edel said it’s not uncommon for the market to overestimate inflation or prematurely anticipate rate hikes but warned chairman Jay Powell that his resolve is likely to be tested as the economy strengthens and prices move materially higher.

He said: “While the Fed has signalled interest rates will be on hold through 2023, Fed Funds futures are already pricing in at least one increase by the end of 2022. According to BCA Research, the OIS swaps curve is currently discounting four increases, or +1.00% by the end of 2023. Last month’s correction in the bond market is not the last tantrum we are likely to see.

“In the short term, the Fed may be right, inflation might spike higher in 2021, but the move will likely be transitory. Supply chain disruptions will work themselves through, and even though fiscal policy is of a magnitude not seen since WWII and will create a sizable sugar rush of economic growth, its impact will also fade.”

He added that while monetary and fiscal policy coming out of Washington has provided a rainbow of optimism, both carry longer-term risks.

“According to UBS, 2.5% inflation, as indicated by 10-year breakeven rates, could be a problem for the S&P 500, while most fund managers, as indicated in a recent BofA survey, believe 10-year Treasury yields over 2% could cause a 10% correction in stocks.

“These levels will likely be challenged over the next several months, as will the current pace and direction of monetary and fiscal policy. While we still expect the course of least resistance for markets this year to be higher, it won’t be as easy as last year. Expect a few stumbles along the way and the inflation debate heats up.”