Vogue: move to the (inflation and rates) music
Not so long ago it was voguish for central bankers to admit that they had been awful at forecasting inflation and announce that they would wait to see persistent inflationary pressure before they believed in it again. But, despite professing that the current wave of inflation is temporary, the Bank of England and the Federal Reserve are talking as if they believe their forecasts again.
Markets are in the same boat: only two years since the Phillips Curve was declared ‘dead’, it’s made a Lazarus-esque comeback.
We try not to pick sides in these debates. Right now, we believe the most important thing to recognise is that the debate about inflation is unlikely to go on for long without a strong consensus forming on one side or the other. We therefore aim to construct portfolios that will benefit from that debate concluding, rather than backing one side.
That is not to say we lack strong views about inflation. In particular, we think that inflation remains more a global than a local phenomenon and that it is difficult to generate inflationary pressure while China pursues what we see as disinflationary policies. However:
a) We believe it is necessary to be humble about our ability to model inflation. In fact, we believe that nobody has a good model for inflation. Rather, we see it as vitally important for us to recognise what other market participants and central banks think matters for inflation – domestic wage pressure being top of the list. In understanding what is important to other people’s arguments, we can better understand when they are likely to be motivated buyers or sellers.
b) We believe portfolios can be positioned to prosper in both inflationary and disinflationary environments. The key, in our view, is to recognise that debates about the nature of inflationary pressure cannot last forever; they will ultimately be resolved by events.
We believe there is a three-step process to higher interest rates for markets. In step one, the market asks ‘will growth be high?’. In step two, ‘does high growth generate inflation?’ And in step three, ‘how far do rates have to go to slow growth?’ Markets have been debating step two for a while now, but this debate has a time limit.
Interest rate and inflation positions can play two roles in fixed-income portfolios. The first is as a source of absolute return. So, looking to prosper in both high and low inflation environments rather than taking a side, at the moment we want to position portfolios to benefit from increasing consensus about high or low inflation.
This means holding things like 10s30s flatteners (where we overweight 30-year bonds and sell 10-year bonds), which we believe would work in either extreme. Historically, this part of the interest rate curve flattens as central banks hike rates. We still believe that this is the case – but, because interest rates around the world are so close to their lower bounds, we also believe that this part of the curve will flatten in a disinflationary environment.
In fact, we’ve seen that very recently. As 10-year gilts have fallen below 0.75%, the 30-year gilt yield has begun to fall faster than the 10-year gilt yield. So even though low interest rates may be viewed as a source of concern for fixed-income managers, we believe we can use the special dynamics they create to our advantage.
The second use of rates and inflation positions is to complement credit exposures, as they can help smooth performance during macroeconomic shocks.
Traditionally, government bond holdings (more generally, duration) have provided positive returns when risky assets have suffered drawdowns. However, as interest rates have fallen towards their lower bounds, the ability of duration to offer such protection has diminished – yet the ability of duration to suffer negative returns when interest rates rise has not diminished.
Consequently, when interest rates are very low – as they are in the UK – we believe it is best to have a much smaller core duration holding and to focus on government bonds where we believe yields are high enough that they can offer protection in negative risk environments.
We also want to look outside the government bond market for the insurance that duration would have previously provided. One of the key ways we do this is by selling inflation exposure in those markets where inflation is already priced at or above levels consistent with central-bank targets.
What if inflationary pressure increases? Well, if inflationary pressure is expected to increase, what typically happens is that markets anticipate central banks raising interest rates to reduce inflationary pressure. In market pricing, the net result is higher yields (government bonds make a loss) and relatively unchanged inflation pricing. You can see that relationship in this chart of US inflation pricing and 10-year US Treasury yields.