Some of the world’s biggest bond investors say the market is wrong to expect central banks to score a long-term win in the war against inflation.
There’s little doubt that interest-rate hikes from policy makers in the US and Europe will pull consumer-price increases down from the fastest pace in decades by slowing economic growth or setting off recessions.
But the retreat of inflation from its peak isn’t likely to mark a return to the price stability of the recent past because of stark shifts in the world economy, according to a broad group of investors and strategists at firms including Pacific Investment Management Co., Capital Group and Union Investment.
During the period of expanding globalization, cheap commodities and low labor costs helped keep inflation at bay. Now, that’s starting to reverse. Oil and gas prices are elevated as nations sever ties with Russia over the Ukraine war. Businesses are weighing political tensions while rebuilding frayed supply chains. And tight labor markets are giving workers the power to push for higher pay.
That has money managers who oversee trillions of dollars bracing for inflation to hold well above the roughly 2% level targeted by major central banks. To guard against that risk, they have been buying inflation-protected bonds, boosting exposure to commodities and expanding cash holdings instead of plowing it directly into bonds, wagering that consumer-price increases won’t quickly pull back to levels seen in recent decades.
“The last twenty years of the great moderation -- that’s fully behind us now,” said Tiffany Wilding, North American economist at Pimco, which had about $1.8 trillion under management at the end of June. She anticipates a period of highly volatile inflation as the world adjusts to changes that will “lead to higher input costs in general that should result in a multi-year price level adjustment.”
The views contrast with speculation that price pressures will ease so much that the Federal Reserve may start cutting interest rates next year to jump-start economic growth. Benchmark 10-year Treasury yields are holding around 3%, about half a percentage point below the mid-June peak. And a bond-market proxy of US inflation expectations over the next two years has been cut nearly in half since March to about 2.7%, not all that far above the 1.9% average increase in a broad price gauge in the 20 years before the pandemic.
Both policy makers and markets have been surprised by how stubbornly high inflation has been, since it was initially thought to be a temporary side effect of the pandemic that would fade once economies reopened. On Wednesday, the UK reported that consumer prices increased at a faster-than-expected pace of 10.1% in July, the most since 1982. That surprised traders, who dumped 2-year government bonds, triggering a steep jump in yields.
“The view in the market that central banks will be in a position to cut rates in a number of countries will be challenged in due course,” Ivailo Vesselinov, chief strategist at Emso Asset Management, who expects the yields on slightly longer dated bonds to jump as the realization that inflation will be more persistent sinks in.
No one expects current levels of inflation to last, making the debate about whether it has crested yet or not beside the point. The key question is what economies are facing over the next three to five years, when many investors are expecting repeated flare-ups in price pressures akin those during the geopolitical turmoil of the 1970s.