Underlying inflation settles at 4%. Sure, inflation will decelerate from the high single digits, but the signs are clear that some of this inflation has become entrenched. The pandemic-induced output gap is about to be closed, and the U.S. is arguably already operating at full employment, based on rising wage pressures and the ongoing difficulty in hiring. Companies are also indicating that they will pass along increased costs through to consumers. Yet central banks are a long way from meaningfully leaning into all of this. While a lot of the inflation pressures are supply side oriented and fiscally juiced, the central banks must appreciate that ultra-low cost funding is enabling governments, businesses and households to easily finance expenditures—regardless of the cost increases.
The 10-year U.S. Treasury hits 3%. It’s really not surprising that the 10-year closed 2021 at 1.51%, it’s just damn impressive. Despite significant fiscal stimulus, a broadening recovery and surging inflation, central banks were, for most of 2021, curiously disinterested in ending their large-scale asset purchases, much less raising rates. With the ongoing Federal Reserve (Fed) purchases and money coming in from negative-yielding foreign markets, perhaps the real surprise in 2021 was that yields even managed to rise at all in the U.S. bond market. That will change in a big way in 2022. The Fed should be winding up its balance sheet expansion in Q1 and is expected to hike rates by mid-year. Other central banks will likely follow as inflation remains resilient. Without the central bank purchases and with cash now offering some yield, let’s see how willing investors are to continue to purchase long-duration government debt at significantly negative real yields.
The ECB raises rates in 2022. Methinks they doth protest too much…with apologies to Shakespeare. We applaud the European Central Bank (ECB) for announcing a tapering of its asset purchases by phasing out PEPP in March 2022, but it’s unclear how the ECB will make it to 2023 without raising rates, especially as it has raised its inflation projections for 2022 from 1.7% to 3.2% (higher than the Fed’s estimate for the U.S.). Perhaps when global inflationary pressures don’t abate over the course of 2022, the ECB may realize that raising rates is also an opportunity to begin normalizing distorted markets and reducing the penalty to savers.
Brazil is one of the best-performing bond markets. The Banco Central do Brasil (BCB) has made the difficult decision to battle inflation far earlier than its central banking peers. Rate hikes of 725 basis points have pushed its official SELIC rate to 9.25%, just below the current rate of inflation (~10.7%). It’s possible that as inflation cools the BCB will be one of the very few central banks with its official rate above the rate of inflation. As other central banks are scrambling, the Brazilian bond market should be stable, thanks to the early action of the BCB giving investors the opportunity to cash in on high real interest rates.
Cash is the best-returning asset class. Central banks taking away the punch bowl is generally a concern for asset prices. After the Great Financial Crisis, policy support was withdrawn so gradually, the markets were largely undisturbed. This time, central banks look so far behind the curve, an acceleration in their tightening process looks inevitable. This means faster and more rate hikes than the market is currently pricing in. Asset valuations will be punished by the dramatically higher discount rates they will face during 2022. Cash is no longer trash.
Bob Michele is global head of fixed income and CIO at J.P. Morgan Asset Management. Kelsey Berro is a fixed-income portfolio manager at J.P. Morgan Asset Management.