Global bond traders seek protection against the threat of inflation

(Bloomberg) — Just as bond traders grow more confident that inflation is finally under control, one camp of investors is quietly building hedges against the risk of a future price rise.

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These fund managers accumulate positions that would cushion fixed income returns in the event of an inflationary shock. Wall Street strategists also recommend taking advantage of the decline in market-based measures of future inflation to build protection on the cheap.

It is not a consensus transaction. After all, a growing batch of data, including benign inflation readings from the US and UK, suggest price pressures are easing after years of monetary tightening by global central banks. Interest rate cuts are now in play and recession has replaced inflation as the dominant concern. That promising news sent benchmark bond yields much lower — but perhaps too far, some say.

“We think recession fears are overblown, but inflation risks are probably understated at current yield levels,” said John Bilton, head of multi-asset strategy at JP Morgan Asset Management. Bilton said he remained “broadly neutral” on duration or interest rate risk exposure, given that there were “a handful of forces that could push inflation higher”.

While price growth has eased significantly from Covid-era highs, the downward path has been bumpy and inflation in some areas has proved tenacious. The US economy remains resilient, as strong July retail sales figures showed, while a range of threats from US-China trade tensions and shipping disruptions to heavy public spending and turmoil in the Middle East only to increase inflationary risks.

For all these reasons, some investors see the need for insurance.

“If inflation turns out to be more persistent or rises again, that could derail your portfolio if you have duration exposure,” said Marie-Anne Allier, who owns a €5.6bn fixed income portfolio ($6.2 billion) in Carmignac.

Allier believes that the market has become too optimistic about the outlook for inflation. As an offset, it deployed three- and five-year euro and US inflation-linked derivative hedges, as well as three-year inflation-linked Spanish bonds.

Central bankers around the world are also stressing the need for vigilance, even as they turn their attention to growth risks and signal rate cuts ahead. Investors will be looking for clues about how the Fed manages that balance when Chairman Jerome Powell and others speak at the central bank’s symposium next week in Jackson Hole, Wyoming.

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“Over the last two or three years, central banks have been very focused on inflation, now they’re going to focus and focus a little bit more on the labor market,” said Neil Sutherland, portfolio manager at Schroder Investment Management. “I’m not saying the war on inflation is over,” he added, but “they’ve done a pretty good job on that front.”

However, many investors believe that the inflation index has fallen too far. Consider the US five-year yield, the difference between inflation-linked yields and nominal yields of similar maturities, and a proxy for the average rate of price increases over the period. It has fallen sharply in recent weeks as recession fears flared and is now trading down about 2% for the first time since early 2021.

A near-term tipping point could come shortly after the US presidential election, should it result in a victory for Republican Donald Trump. He is campaigning on a platform of tax cuts, tariff hikes and immigration crackdowns – all of which are potentially inflationary.

Gareth Hill, a fund manager at Royal London Asset Management Ltd., added U.S. inflation exposure to his portfolios through the five-year yield curve — essentially a bet that Treasury inflation-protected securities (TIPS) will outperform nominal bonds for five years. Elections aside, Hill still sees value in trade, arguing that “the last mile in the fight against inflation is the hardest.”

Outside the US, price data from many developed countries is still proving hard to digest. Australia recently ruled out an interest rate cut in the next six months, with inflation still at 3.8%, while euro zone inflation unexpectedly accelerated in July. Barclays Plc strategists recommend positioning for higher inflation in the eurozone over the next year through short-term swaps.

Even Japan, finally emerging from decades of deflation, worries investors. Roger Hallam, global head of rates at Vanguard, says the firm is cautious about both Japanese bonds and UK gilts – where core inflation is still at 3.3%.

Above forever

Longer term, structural changes in the global economy to address challenges such as climate change and an aging population, as well as rising government deficits, mean that inflation – and interest rates – may settle in a higher range.

Amelie Derambure, a portfolio manager at Amundi SA, is already positioning for this prospect through long-dated TIPS.

“The market is right to play the pace of disinflation in the short term,” she said. “It’s more debatable in the medium to long term.”

Citigroup Inc. recently initiated a long US 10-year yield threshold of just over 2.10% around Friday. Strategists expect long-term inflation expectations to rise as the Fed begins to ease.

What Bloomberg strategists say…

“This is probably not the time to take the view of higher yields, but there is a non-negligible chance – not discounted by the market – that inflation will start to rise again, limiting the amount the Fed can cut and disappointing expectations for rate cuts to market prices and thus supporting yields.”

— Simon White, macro strategist

For many, inflation is not something to worry about right now. Eva Sun-Wai of M&G Investments, for example, says that with US commodity prices possibly already in deflation, there is a greater risk for central banks to keep policy tight for too long.

Others see long-term inflation as a risk, but caution against buying coverage prematurely, as it could still get cheaper. Erik Weisman, chief economist and portfolio manager at MFS Investment Management, believes the US yield could fall by as much as 100 basis points if the so-called hard landing materializes.

It’s a risk also flagged by Martin van Vliet, global macro fixed income strategist at Robeco. He is considering closing a deal that took advantage of the drop in the 30-year euro inflation swap from around 2.80% last September to 2.30% now.

There is also a latent vein of skepticism about how much inflation-linked bonds really provide after the notes have suffered significant losses as prices rise in 2022.

But Fidelity International’s Tim Foster says the securities have proven their value over the long term. He points to data showing that TIPS with maturities of one to 10 years have outperformed their nominal counterparts in 17 of the past 25 calendar years and are on track to do so again in 2024.

“More often than not, markets fail to price in inflation risks; it is much more likely to be a miss well above expectations than a miss well below expectations,” he said. “If investors become complacent about inflation, it wouldn’t be the first time.”

What to watch

• Economic data:

  • Aug. 19: driving index

  • August 20: Philadelphia Fed non-manufacturing index

  • August 21: MBA mortgage applications; BLS Preliminary Annual Review of Payrolls

  • August 22: Chicago Fed National Activity Index; unemployment claims; S&P Global US manufacturing, services and composite PMIs; sales of existing homes; Kansas City Fed Manufacturing Index

  • August 23: Bloomberg US Economic Survey; sales of new homes

• Fed calendar:

  • August 19: Fed Governor Christopher Waller

  • August 20: Atlanta Fed President Raphael Bostic; Fed Vice Chairman for Supervision Michael Barr

  • August 21: Minutes of the Federal Open Market Committee’s July meeting

  • August 22: Annual Kansas City Fed Symposium in Jackson Hole, Wyoming

  • August 23: President Jerome Powell speaks in Jackson Hole

• Auction calendar:

  • August 19: 13, 26 week bills

  • August 20: 42-day cash management bills

  • August 21: 17-week bills; 20-year bonds

  • August 22: 4, 8 week bills; 30-year inflation-protected Treasury securities

–With assistance from Ruth Carson and Michael Mackenzie.

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