Investors Quietly Hedge Against Future Inflation Risks Amid Market Optimism
Monday, Aug 19, 2024 1:01 am ET
As bond traders grow increasingly confident that inflation will eventually be controlled, a group of investors is quietly building positions to hedge against the potential risk of future price surges.
Some fund managers are accumulating positions to cushion fixed-income returns in case of an inflation shock. Strategists on Wall Street suggest taking advantage of market predictions that future inflation will decrease and establish protective positions at low costs.
This is not a consensus trade. After all, mounting data, including favorable inflation reports from the US and UK, indicates that price pressures are easing following years of monetary tightening by global central banks. Recession concerns have overtaken inflation as the primary worry, and rate cuts seem inevitable. This optimistic news has driven benchmark bond yields sharply lower. However, some believe the market may have gone too far.
John Bilton, head of global multi-asset strategy at JPMorgan Asset Management, argues that concerns about a recession are overstated at current yield levels, possibly underestimating inflation risks. Bilton maintains a "neutral" stance on rate risk exposure, citing forces that could push inflation higher.
Although inflation has significantly decelerated from its pandemic highs, the path downward is bumpy, and in some regions, inflation proves stubborn.
Robust retail sales data from July suggest persistent US economic resilience, while a range of threats from international trade tensions and shipping disruptions to massive public spending and unrest in the Middle East add to inflationary risks.
For these reasons, some investors see it necessary to take measures against potential inflation rebounds.
Marie-Anne Allier, who manages a €5.6 billion fixed-income portfolio at Carmignac, believes that if inflation proves more persistent or rises again, it could undermine portfolios exposed to rate risk. To hedge her bets, Allier uses three-year and five-year derivatives linked to euro and US inflation, along with three-year Spanish inflation-linked bonds.
Central bankers worldwide are emphasizing the need for vigilance even as their focus shifts to growth risks and signals rate cuts. At this week's symposium in Jackson Hole, Wyoming, speeches from Federal Reserve Chair Jerome Powell and others will be closely watched for clues on balancing inflation and growth.
Despite the shift in focus, many investors feel inflation indicators might have fallen too far. The breakeven rate on US five-year TIPS, for instance, has sharply declined to around 2%, marking the first time since 2021 amidst burgeoning recession fears. The breakeven rate reflects the gap between TIPS yields and similar maturity nominal yields, serving as a proxy for average price increases over that period.
In the event of a Republican presidential candidate like Trump winning the US election, recent crises might quickly re-emerge. Policies such as tax cuts, tariff increases, and immigration curbs could all incite inflation.
Gareth Hill, a fund manager at Royal London Asset Management Ltd., has been increasing US inflation exposure through five-year TIPS breakeven rates, essentially betting that five-year TIPS will perform better than nominal bonds of similar maturity.
Even without the election, Hill finds this trade valuable, asserting, “The last mile of the inflation fight is the toughest.”
Outside the US, inflation data in many developed countries remain worrisome. Australia has almost ruled out rate cuts in the next six months with an inflation rate stuck at 3.8%, while Eurozone inflation unexpectedly accelerated in July. Barclays' strategists recommend preparing for higher Eurozone inflation next year via short-term swap trades.
Even Japan, long plagued by deflation, is causing investor concern. Roger Hallam, Vanguard's global head of rates, exercised caution over Japanese and UK government bonds, given the UK’s core inflation rate still at 3.3%.
Structurally, longer-term inflation and interest rates are likely to be higher. Global efforts to handle challenges such as climate change and an aging population, along with rising government deficits, suggest shifts to a higher range.
Amelie Derambure, a portfolio manager at Amundi SA, is preparing for this scenario with long-term TIPS. She believes the market is correct to capitalize on the anti-inflation momentum in the short term, yet questions the medium to long-term trends. Citi strategists anticipate long-term inflation expectations will rise as the Fed begins easing.
Bloomberg macro strategist Simon White notes, “It's not time yet for a higher yield view, but the possibility of a resurgent inflation limiting Fed rate cuts and defying market expectations should not be ignored.” He stressed that many have become too complacent about inflation risks.
For many investors, the primary worry might no longer be inflation. Eva Sun-Wai from M&G Investments says that US core goods prices might have already slipped into deflation, posing a higher risk of the Fed maintaining its tightening policy longer.
Some argue that while long-term inflation remains a risk, early hedging might be premature given the potential for further cost reductions. Erik Weisman from MFS Investment Management warns that a "hard landing" could narrow US TIPS breakeven points by up to 100 basis points.
Robeco's global macro fixed-income strategist Martin van Vliet notes this risk, hinting at ending a profitable trade on the 30-year euro inflation swap from last September’s 2.80% to the current 2.30%.
Following 2022 when TIPS saw their returns plummet due to soaring prices, questions arise on how much protection these bonds can truly offer.
However, Tim Foster from Fidelity International asserts that the long-term value of these securities remains evident, highlighting data that shows one-year to ten-year TIPS outperformed their nominal equivalents in 17 out of the past 25 calendar years and may do so again in 2024.
Foster emphasizes, “The market often fails to price in inflation risks adequately, with overestimates far more common than underestimates. Investors becoming complacent about inflation is nothing new.”
Some fund managers are accumulating positions to cushion fixed-income returns in case of an inflation shock. Strategists on Wall Street suggest taking advantage of market predictions that future inflation will decrease and establish protective positions at low costs.
This is not a consensus trade. After all, mounting data, including favorable inflation reports from the US and UK, indicates that price pressures are easing following years of monetary tightening by global central banks. Recession concerns have overtaken inflation as the primary worry, and rate cuts seem inevitable. This optimistic news has driven benchmark bond yields sharply lower. However, some believe the market may have gone too far.
John Bilton, head of global multi-asset strategy at JPMorgan Asset Management, argues that concerns about a recession are overstated at current yield levels, possibly underestimating inflation risks. Bilton maintains a "neutral" stance on rate risk exposure, citing forces that could push inflation higher.
Although inflation has significantly decelerated from its pandemic highs, the path downward is bumpy, and in some regions, inflation proves stubborn.
Robust retail sales data from July suggest persistent US economic resilience, while a range of threats from international trade tensions and shipping disruptions to massive public spending and unrest in the Middle East add to inflationary risks.
For these reasons, some investors see it necessary to take measures against potential inflation rebounds.
Marie-Anne Allier, who manages a €5.6 billion fixed-income portfolio at Carmignac, believes that if inflation proves more persistent or rises again, it could undermine portfolios exposed to rate risk. To hedge her bets, Allier uses three-year and five-year derivatives linked to euro and US inflation, along with three-year Spanish inflation-linked bonds.
Central bankers worldwide are emphasizing the need for vigilance even as their focus shifts to growth risks and signals rate cuts. At this week's symposium in Jackson Hole, Wyoming, speeches from Federal Reserve Chair Jerome Powell and others will be closely watched for clues on balancing inflation and growth.
Despite the shift in focus, many investors feel inflation indicators might have fallen too far. The breakeven rate on US five-year TIPS, for instance, has sharply declined to around 2%, marking the first time since 2021 amidst burgeoning recession fears. The breakeven rate reflects the gap between TIPS yields and similar maturity nominal yields, serving as a proxy for average price increases over that period.
In the event of a Republican presidential candidate like Trump winning the US election, recent crises might quickly re-emerge. Policies such as tax cuts, tariff increases, and immigration curbs could all incite inflation.
Gareth Hill, a fund manager at Royal London Asset Management Ltd., has been increasing US inflation exposure through five-year TIPS breakeven rates, essentially betting that five-year TIPS will perform better than nominal bonds of similar maturity.
Even without the election, Hill finds this trade valuable, asserting, “The last mile of the inflation fight is the toughest.”
Outside the US, inflation data in many developed countries remain worrisome. Australia has almost ruled out rate cuts in the next six months with an inflation rate stuck at 3.8%, while Eurozone inflation unexpectedly accelerated in July. Barclays' strategists recommend preparing for higher Eurozone inflation next year via short-term swap trades.
Even Japan, long plagued by deflation, is causing investor concern. Roger Hallam, Vanguard's global head of rates, exercised caution over Japanese and UK government bonds, given the UK’s core inflation rate still at 3.3%.
Structurally, longer-term inflation and interest rates are likely to be higher. Global efforts to handle challenges such as climate change and an aging population, along with rising government deficits, suggest shifts to a higher range.
Amelie Derambure, a portfolio manager at Amundi SA, is preparing for this scenario with long-term TIPS. She believes the market is correct to capitalize on the anti-inflation momentum in the short term, yet questions the medium to long-term trends. Citi strategists anticipate long-term inflation expectations will rise as the Fed begins easing.
Bloomberg macro strategist Simon White notes, “It's not time yet for a higher yield view, but the possibility of a resurgent inflation limiting Fed rate cuts and defying market expectations should not be ignored.” He stressed that many have become too complacent about inflation risks.
For many investors, the primary worry might no longer be inflation. Eva Sun-Wai from M&G Investments says that US core goods prices might have already slipped into deflation, posing a higher risk of the Fed maintaining its tightening policy longer.
Some argue that while long-term inflation remains a risk, early hedging might be premature given the potential for further cost reductions. Erik Weisman from MFS Investment Management warns that a "hard landing" could narrow US TIPS breakeven points by up to 100 basis points.
Robeco's global macro fixed-income strategist Martin van Vliet notes this risk, hinting at ending a profitable trade on the 30-year euro inflation swap from last September’s 2.80% to the current 2.30%.
Following 2022 when TIPS saw their returns plummet due to soaring prices, questions arise on how much protection these bonds can truly offer.
However, Tim Foster from Fidelity International asserts that the long-term value of these securities remains evident, highlighting data that shows one-year to ten-year TIPS outperformed their nominal equivalents in 17 out of the past 25 calendar years and may do so again in 2024.
Foster emphasizes, “The market often fails to price in inflation risks adequately, with overestimates far more common than underestimates. Investors becoming complacent about inflation is nothing new.”