The future is inflationary?


Craig Inches, Head of Rates and Cash

25 July 2019

Central banks are hell bent on cutting interest rates
At the US Federal Reserve’s (Fed) June meeting, eight members signalled that they thought a rate cut would be appropriate this year.
Meanwhile, Mario Draghi disclosed that the European Central Bank (ECB) is actively discussing shifting its inflation target to be symmetrical around 2%; rather than the current target of “below, but close to, 2%”.
Reflecting this dovish sentiment, the market is currently pricing in four rate cuts from the Fed over the next 12 months, with one from both the ECB and the Bank of England (BoE) over the same timeframe.
Last week’s economic data: mixed, but on the stronger side
The UK saw a strong, expectation topping, improvement in retail sales alongside higher average earnings. At the same time, Consumer Price Index (CPI) inflation remained steady.
Similarly, the US saw a robust retail sales number and a strong bounce-back in the Philadelphia Fed Business Outlook Survey.
The picture in Europe was somewhat less rosy, with a disappointing reading on the ZEW economic sentiment indicator, although CPI inflation was slightly higher.
So what does this all mean for investors?
The combination of the recent uptick in economic data with central banks determined to cut rates regardless is highly constructive for break-evens (i.e. index linked bonds outperforming nominal bonds). Both elements provide inflationary pressure, and so we have unsurprisingly seen a recent pick-up in global inflation expectations as priced by the market.
Owing to our perception that US and European break-evens are relatively cheap, we are well positioned for this outlook, with overweight exposures to these markets. With the economic backdrop expected to become more inflationary, this positioning should be positive for performance.

Central banks are hell bent on cutting interest rates

At the US Federal Reserve’s (Fed) June meeting, eight members signalled that they thought a rate cut would be appropriate this year.

Meanwhile, Mario Draghi disclosed that the European Central Bank (ECB) is actively discussing shifting its inflation target to be symmetrical around 2%; rather than the current target of “below, but close to, 2%”.

Reflecting this dovish sentiment, the market is currently pricing in four rate cuts from the Fed over the next 12 months, with one from both the ECB and the Bank of England (BoE) over the same timeframe.

Last week’s economic data: mixed, but on the stronger side

The UK saw a strong, expectation topping, improvement in retail sales alongside higher average earnings. At the same time, Consumer Price Index (CPI) inflation remained steady.

Similarly, the US saw a robust retail sales number and a strong bounce-back in the Philadelphia Fed Business Outlook Survey.

The picture in Europe was somewhat less rosy, with a disappointing reading on the ZEW economic sentiment indicator, although CPI inflation was slightly higher.

So what does this all mean for investors?

The combination of the recent uptick in economic data with central banks determined to cut rates regardless is highly constructive for break-evens (i.e. index linked bonds outperforming nominal bonds). Both elements provide inflationary pressure, and so we have unsurprisingly seen a recent pick-up in global inflation expectations as priced by the market.

Owing to our perception that US and European break-evens are relatively cheap, we are well positioned for this outlook, with overweight exposures to these markets. With the economic backdrop expected to become more inflationary, this positioning should be positive for performance.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.