Inflation fears to deliver volatility and opportunity
For those that found bond market pricing perplexing in the pre-Covid world, April’s strong performance in the face of very strong macro data is hard to explain. Fundamentalist investors could be forgiven for expecting bond yields to be higher on the month as the U.S. economy continued to power ahead driven by extraordinary stimulus and strong data prints.
U.S. employment added 916,000 jobs, significantly higher than pre-Covid averages around 200,000 per month. Retail sales grew by 9.8%, whilst inflation rose to 0.6% month-on-month and 2.6% year-on-year. Inflation will continue to rise in the coming months on a substantial base effect (as outlined in our recent whitepaper “Over the Inflation Hill”) but this performance of the bond market has occurred without an ascribed media narrative. Bond markets are renowned for their predictive capabilities – is the performance based on an assumption of peak data now that the U.S. stimulus cheques have been mailed out? Or perhaps the rally is based on renewed concerns over COVID-19 variants as another possible explanation as the new Indian COVID-19 variant is proving immune to vaccinations. Geopolitical fears are also heightened around possible flashpoints like Taiwan. Perhaps the market moved over its skies on re-setting to higher bond yields and has moved too far on expectation.
Looking ahead, markets still need to absorb a substantial rise in base affect inflation in the U.S. This is due to the large -0.7 monthly print from April 2020 falling out of the year-on-year calculation. This will see headline year-on-year inflation rise to at least 3.3% with a flat monthly print, so the likelihood of a print in the mid to upper threes is likely for a short period. This will ignite substantial media narrative about the return of inflation, but this is primarily reflation that will fall away as the “inflation hill” is created.
Remember, inflation is sustained price increases, not one-offs due to supply disruptions. We struggle to believe that can happen on a secular basis. That should deliver more volatility ahead, but also provide a wonderful opportunity.
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Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...