• Over the past month, central banks have been signalling more clearly that they may have done enough tightening of policy. Yet, longer-term bond yields have risen sharply, breaking through last year’s highs and reaching their highest levels since before the GFC.
• Much of this reflects markets factoring in the accompanying message from policymakers, that rates may have peaked, but cuts are a long way away. We concur. Only a mild macro downturn suggests rates will need to be held higher for longer to ensure inflation returns to target.
• Markets are also fretting that the pause in hiking will leave policymakers with more hikes to achieve the ‘last mile’ of the disinflation from 3% to 2%. But we see this as unlikely. Inside, we discuss the lesser-known thesis of ‘opportunistic disinflation’ and why we believe this is exactly the path that central banks are now actively embracing.
• The key tenet of this thesis is that when inflation is ‘moderate’ (around 3–4%, but not higher), yet still above the inflation target (which for many countries is around 2%), the likely upswing in unemployment associated with further hikes to force inflation down to target is seen to be too great to accept.
Over the past month, central banks have been signalling more clearly that they may have done enough tightening of policy. Yet, longer-term bond yields have risen sharply, breaking through last year’s highs and reaching their highest levels since before the GFC. Much of this reflects interest rate markets factoring in the accompanying message from policymakers, that interest rates may have peaked, but cuts are a long way away.
We concur, to a degree. Indeed, one of our key calls for H2 2023 was that fixed income was a multi-year overweight. Easing inflation, but only a mild macro downturn, suggests rates will need to be held higher to ensure inflation returns to target. The typical peak and pivot in rates (and strong equity rally) seems less likely, though not impossible, this cycle.
Markets are also fretting that the pause in hiking will leave policymakers with more hikes to achieve the ‘last mile’ of the disinflation from 3% to 2%. We see that as unlikely. In this month’s Core Offerings, we discuss the lesser known thesis of ‘opportunistic disinflation’ and why we believe this is exactly the path that central banks are now actively embracing.
In May 1996, Orphanides and Wilcox, employees of the US Federal Reserve (Fed), explored the foundations of what they referred to as ‘a new approach to monetary policy’ in a paper titled “The Opportunistic Approach to Disinflation”. The key tenet of this thesis is that:
“When inflation is moderate but still above the long-run objective, [central banks] should not take deliberate anti-inflation action, but rather should wait for external circumstances—such as favourable supply shocks and unforeseen recessions—to deliver the desired reduction in inflation. While waiting for such circumstances to arise, [central banks] should aggressively resist incipient increases in inflation.” (https://www.federalreserve.gov).
The essence of the thesis is that when inflation is ‘moderate’ (let’s say around 3–4%, but not higher), yet still above the inflation target (which for many countries is around 2%), the ‘sacrifice of output’ (or likely upswing in unemployment) associated with further hikes to force inflation down to target is seen to be ‘too great’ to accept.
Here, “the policymaker…views an inflation rate of 3% more favourably if inflation in the previous period was 4% than if inflation was 2%.” The policymaker is essentially seen to be ‘holding the line’ on inflation at the current level and fighting to prevent an earlier and higher level from reoccurring (and likely tightens only if inflation reaccelerates).
Key is that the opportunistic policymaker focuses on getting inflation down when it is high (and well above target), but concentrates on stabilising output (and keeping the economy growing) when inflation is low. And if inflation is a bit above target, the ‘path of least regret’ is to wait for something other than tighter policy—be that productivity or an unforeseen recession—to ultimately deliver the ‘last mile’ to the inflation target.
The parallels today to the thesis of ‘opportunistic disinflation’ seem clear. Over the past couple of months, key central banks have pronounced the likely end of the hiking cycle, with inflation still well above most targets (chart below). And nor is there the usual evidence of emerging ‘slack’ in jobs markets via rising unemployment. For the Fed, core inflation is now annualising between 2.5–3.0%, close to but still above its target. Elsewhere such as Australia, it is annualising at 3.6%, also moderately above the 2–3% target.
Yet, policymakers are in many cases signalling that policy tightening is likely ‘done’. Of course, given the chequered more recent policy experience of central banks—arguably holding policy too low for too long and having to lift rates rapidly—policymakers may also be quietly questioning whether they have the political capital to pay the price of higher unemployment, if that indeed is required near-term to deliver ‘at-target’ inflation.
Nor does the ‘near’ end of the current tightening cycle reflect central bank expectations that a return of inflation to target is imminent. Far from it. While central banks continue to commit strongly to their inflation targets, forecasts typically don’t have inflation sustainably reaching the respective inflation targets for two years or more.
Despite central banks signalling more clearly that they are approaching the peak of policy tightening, longer-term bond yields have risen sharply, breaking through last year’s highs and reaching their highest levels since before the GFC. As the chart above shows, US 10-year bond yields have risen from 4.2% to 4.6% through September, while Australian 10-years have lifted from 4.0% to 4.4%. Equity markets have also corrected, with the US down around 5%, Australia down about 4% and Europe down 2.5%.
There’s likely to have been both secular (longer-term) and cyclical (short-term) cross currents behind this month’s move higher in bond yields.
From a secular or medium-term perspective, there are likely two main focuses of concern. Firstly, as the chart below shows, there’s a large element of the jump in longer-dated yields related to higher term premia (which can be simplistically viewed as the difference between longer- and shorter-term yields, reflecting the compensation to investors for the uncertainty associated with lending long). In other words, ‘real yields’ are rising to reflect uncertainty about how strong growth might be in the future, and the ‘neutral’ or average policy rate that will be needed to maintain low inflation against this backdrop.
Key catalysts here likely include the Fed’s own September pivot to a slower pace of cutting the Fed funds rate over the forecast horizon (from four planned cuts to only two planned cuts in 2024), as well as the evident underlying resilience of global (and particularly US) growth momentum. The stronger global and US growth (and productivity) backdrop associated with renewable capex and the energy transition may also be a factor, as is the potential for Japan to move away from zero rates given its stronger growth outlook.
Secondly, bond yields are also likely responding to concerns associated with the risk that inflation over the coming decade may well average a higher level than it did previously. In the seven years prior to the pandemic, US headline inflation averaged just 1.5% (below their 2% target), while in Australia it averaged 1.9% (below the 2–3% target range). This was an environment that led central banks to trend policy interest rates lower (ultimately reaching zero) to attempt to lift inflation to their respective inflation targets.
In our August Core Offerings, one of our key calls for the year ahead was that fixed income was a multi-year overweight, reflecting our belief that inflation will likely settle at a higher level over the coming decade, limiting the extent to which central banks could return yields to zero while also slowing their likely pace of rate cuts in the period ahead. We identified longer-term ‘cost’ drivers such as shifting supply chains, ageing workforces, and the energy transition as factors likely to contribute to ‘on average’ stickier secular inflation.
From a cyclical or shorter-term perspective, yields have also likely risen recently on the back of concerns that inflation remains too high. At the same time, central banks are indicating a lack of desire to tighten further and force inflation imminently back to target, potentially causing inflationary problems down the track. Simmering concerns about China’s financial stability as a number of large property firms have proven insolvent, as well as the recent reacceleration in energy prices as producers limit supply has also likely impacted.
Other cyclical factors also include the increasing supply of US fiscal debt (and a potential government shutdown) associated with a worryingly unfettered fiscal position, while the ‘long’ positioning of many asset allocators into fixed income has also led investors to worry about who the marginal buyers of bonds are in the period ahead.
One of our key calls remains the likelihood that inflation will settle at a higher level than in the past, arguing for a higher interest rate structure (and income environment) for assets. However, we also believe that we are entering a new phase of slower growth with the likelihood that inflation, while above target, will continue to moderate over the coming year. Indeed, recent monthly data reveal actual inflation rates ‘annualising’ much closer to their targets than the more widely reported annual CPI measures. US core inflation has averaged 0.2% per month for the past three months, annualising at around 2.5%.
Further improvement in inflation trends should reflect:
With inflation moderating, albeit likely to be volatile over coming months, we expect annual rates will continue to trend closer to central bank targets over the coming year. Given this, while central banks don’t appear confident to definitively proclaim the peak in rates at this juncture, their comments also suggest they have little appetite to force inflation to target near-term via multiple further hikes. Of course, the price for the pursuit of ‘opportunistic disinflation’ (in tandem with latent worries about upward secular inflation pressures)—and accepting a relatively slow approach of inflation to its target over multiple years—is that policy rates seem destined to remain more restrictive for longer.
Our expectation of a near-term peak in policy rates is coming into view. But the recent sharp rise in government bond yields has clearly moved at odds with our preference for tactical allocating to fixed income relative to equities (albeit equities are also stumbling more recently in the face of higher yields). However, we believe there is growing evidence of a further slowing in global growth over the coming quarters. This should add to recent disinflationary pressures and ensure the next wave of policy moves from central banks is lower, even if that doesn’t commence until the middle of 2024.
To the extent we argue real rates are likely to be higher on average over the coming 5–10 years, they are likely to correlate with steady-state 10-year US and Australia government bond yields between 3.0–3.5%, well above the past decade, but still a full percent below current levels. The relatively resilient global macro backdrop, and absence of further hikes, should also ensure quality corporate credit remains an attractive contributor to portfolios.
Reflecting this, we remain comfortable retaining our overweight to fixed income relative to equities. However, given our longer-term secular concerns, our positioning will continue to be nimble. Key risks to our view for a moderate rally in bond yields over the next year or so is a reacceleration in inflation, that even within an opportunistic disinflation framework requires central banks to recommence policy tightening. A crisis in US fiscal policy is also a risk to lower long-term bond yields over the coming year.
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