BlueBay AM: Inflation is yet to peak

July 16, 2021

Mark Dowding, CIO at BlueBay Asset Management, focuses on rising inflation rates and potential responses from the Fed, ECB and BOE in his latest market commentary:

• Inflation is yet to peak: It seems to BlueBay that prices will continue to grow well above the Fed’s 2% target rate through 2022 and beyond. 
• Fed tapering: BlueBay continues to think that two strong jobs reports in July and August may be enough to trigger a debate with respect to the Fed tapering its bond purchases at its September meeting. 
• Bank of England: If moves to continue to remove Covid restrictions in the UK prove successful in the next couple of months, this could see the Bank of England move in a more hawkish direction. 
• European Central Bank: ECB comments suggest to BlueBay that it will increase bond purchases under the APP programme, even as it starts to wind down the PEPP. 
• Yields: BlueBay remains confident that yields are set to move higher in the weeks ahead and believe that this warrants holding a short duration position with relatively high levels of conviction. 

 
Downding: 'US inflation reports surprised to the upside for the third month in a row in data released during the past week. Headline CPI now stands at 5.4%, with core prices rising by 4.5% in the past year and producer input prices accelerating by 7.3%.

With surveys such as the Fed’s Beige Book also reporting scope for further gains, it seems to us that inflation is yet to peak.

If we are correct in our analysis that inflation expectations and wages move higher in the months to come, then it seems that prices will continue to grow well above the Fed’s 2% target rate through 2022 and beyond.

It is well understood that transitory elements are accounting for a portion of the recent CPI acceleration, with half the rise in the past month coming from a surge in second-hand car prices following bottlenecks in auto production in the wake of semiconductor shortages.

However, it seems increasingly clear that away from these temporary factors, corporates are finding themselves in a position to pass on higher prices, in a way that we haven’t seen during the past twenty years or more.

Nevertheless, bond markets were once again quick to shrug off any inflation concerns. With the Fed continuing to purchase USD120 billion of securities every month and Powell retaining a dovish stance, it might seem that the central bank has concluded that the level of prices is an exogenous and random variable, which it sees little merit in seeking to control.

However, the belief that inflation will return to target of its own accord appears to be taking a lot on trust. With the outlook for economic activity remaining robust, there might appear growing risk that the Fed will need to tighten more aggressively at a later juncture if pressures continue to build.

Powell may currently be seeking to keep his job by aiming to please Biden and colleagues through spurring growth and supporting asset prices in the near term. However, if this comes at the expense of an increased risk of recession close to the next election, then history books may be somewhat scathing in their assessment of a laissez-faire approach to central banking, which Powell seems to have embraced.

In any event, Treasury yields dipped towards the end of the week after it appeared that the recent rally in yields was losing momentum. In our assessment, embedded market expectations for growth and inflation appear much too modest and we continue to think that two strong jobs reports in July and August may be enough to trigger a debate with respect to the Fed tapering its bond purchases at its September meeting – especially if inflation continues to run hot.

In that context, we remain confident that yields are set to move higher in the weeks ahead and believe that this warrants holding a short duration position with relatively high levels of conviction.'

Europe & the UK

'Elsewhere, we favour a long stance in Bunds relative to Gilts on the perception that the European Central bank (ECB) is set to be much more dovish than the Bank of England (BoE), relatively speaking, in the months ahead. ECB comments suggest to us that it will increase bond purchases under the APP programme, even as it starts to wind down the PEPP.

The pandemic will pass, but the need for additional monetary accommodation in order to meet its inflation objective could see such a pivot as early as next week’s ECB meeting.

Meanwhile, in the UK, inflation has surprised to the upside and appears at greater risk of moving higher. Historically, inflation expectations have been less anchored in the UK and if moves to continue to remove Covid restrictions prove successful in the next couple of months, this could see the Bank of England move in a more hawkish direction.'

Global markets

'Elsewhere, we see scope for monetary easing in China. Chinese yields remain materially above levels in other developed markets and we believe there is scope for them to fall.

Elsewhere, we see scope for yield curves to flatten in some emerging market countries where central banks are raising rates pre-emptively.

Indeed, away from the US, we observe a number of central banks paring asset purchase programmes or moving to raise interest rates in the weeks ahead, including Norway, New Zealand, Canada, Korea and others.

Given relative US economic outperformance, there is a sense that the Fed is currently the odd one out.'

Credit & FX

'Activity in credit markets remains relatively quiet with spreads tracking moves in stocks. In the eurozone, prospects for easier ECB policy has helped sovereign spreads a little, but given that valuations are already compressed, there seems little conviction or desire in trying to chase after a move.

In FX, the dollar has been relatively rangebound over the week, with more activity seeming to occur in rates markets over the past several days.'

Looking ahead

'We are focused on identifying signs confirming that US economic activity continues at a brisk pace. This week saw the strongest print from the NFIB survey of smaller businesses for the past eight months. This robust picture continues to fit with anecdotal evidence we see in meetings with corporate management.

We also wonder whether some of the hawkish voices on the Fed could register elevated concerns with respect to inflation and the need to reduce the amount of stimulus they are continuing to pump into the economy.

The pattern of declining yields when inflation rises is not set to last, in our view. Fixed income securities may rise in price when their yields fall, but bonds should be naturally allergic in their reaction to inflation.

We suspect that we may look back at the current period in markets sometime later in the year and view some of the trends we are witnessing as relatively strange. But then there seems no shortage of stupid behaviour around us these days…as reflected in the scenes witnessed around Wembley Stadium last weekend.

At least we can be relieved we won’t be seeing this sort of behaviour at the upcoming Olympics in Tokyo!'