A Narrowing Window for Higher Yields Part 2

Inflation proves a tough dragon to slay. It is becoming increasingly well-understood that the difference between a sustained recovery and a bear market rally for risk assets in 2022 boils down to one...
Chief Investment Office26 Sep 2022
Photo credit: AFP Photo

Inflation proves a tough dragon to slay. It is becoming increasingly well-understood that the difference between a sustained recovery and a bear market rally for risk assets in 2022 boils down to one determinant — inflation. Markets can rally, but inflation remains a clear and present danger as long as it is allowed to outlive expectations. With inflation still hovering near multi-decade highs, central banks will continue to drive their hawkish rhetoric in the hopes that they could jawbone aggregate prices into submission.

Central banks need to walk the talk. As much as the market hopes that “tough talk” would be sufficient to bring prices under control, the data itself does not support this outcome. Looking at data since the mid-1980s, US Consumer Price Indices (CPI) did not moderate sufficiently for a policy pivot until the Fed Funds rate was above the rate of inflation. Given that present levels of inflation have not approached policy rates, there are fears that the Fed would need to raise rates to levels not seen since the 1980s just to bring inflation back down to target. We would, however, caution against excessive paranoia regarding a reversion to a Volcker-era rates environment.

Figure 1: Policy pivots can occur when the Fed Funds rate exceeds CPI, which is projected to occur in 1H23

Source: Bloomberg, DBS

Base effects to the rescue. What could cause inflation prints to moderate in the months ahead, aside from moderating demand and/or a reduction in supply constraints, is a case of simple math — known as base effects. For y/y CPI to still register in the lofty highs of 8-9% from here implies an expectation that the same magnitude of price changes from a year ago would be had a year from now. This is unlikely given that leading indicators of inflation — such as supply chain tightness, producer prices, freight rates, and energy commodities — have already begun to moderate from their highs in June. So long as these indicators do not see the same acceleration as they had in the first half of 2022, simple math dictates that y/y inflation would come down naturally from present levels.

Not if, but when. To approximate a period when policy rates might exceed CPI, we use various estimates of m/m CPI changes (0-0.4% m/m) to estimate the trajectory of future y/y inflation prints, while superimposing that with the expected path of the Fed Funds rate using futures pricing (Figure 1). The analysis shows that the environment for a potential policy turn may open as early as between February–June 2023, which is perhaps why the Fed Funds futures are projecting policy rates to peak at just about 4.7% this cycle.

Stay nimble with short duration credit. The implication of this analysis is twofold. Firstly, bond investors should be cognizant that the bias for interest rates could remain higher for another 6-9 months, and as such, fixed income portfolios should remain short duration (2-4 years) and high-quality to mitigate any effects of the upward drift in rates. Secondly, the window of opportunity to capture yields may be closing sooner than expected, and those with excess cash should begin to deploy funds into high quality credit — not needing to time markets to perfection given that present yields of more than 5.1% in short-dated Investment Grade (IG) credit more than compensates for any volatility in the rates environment that could evolve from here.

Table 1: Expected 1Y returns for short-duration IG credit has large margin of safety

Source: Bloomberg, DBS

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