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Breaking Bonds

Breaking Bonds

Posted November 12, 2021 at 10:45 am
Jeffrey Rosenberg
BlackRock

The bonds that held market expectations and central bank policies closely together during the COVID-era are starting to break. BlackRock’s quant bond experts discuss the latest developments in inflation dynamics, liquidity in the financial system, and changes in China’s policy reaction.

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Key points

01 Inflation raises central bank uncertainty

Inflation looks like it will “stick” around into 2022—leaving the near-term outlook for central bank policy highly uncertain and inflation-adjusted yields on fixed income firmly negative.

02 When the liquidity spigot shuts off

Markets are witnessing an unwinding in the historic amounts of liquidity pumped into the financial system—adding risk to the prolonged period of reach-for-yield behavior.

03 A sea change in China’s policy reaction

China may be shifting its “lather, rinse, repeat” pattern of policy accommodation—creating a potential drag on global growth.

For the past two years, a set of shared assumptions between market participants and policy makers helped create a somewhat benign investment environment. Inflation would be “transitory,” allowing for a prolonged period of accommodative low rates and stable rate expectations. Ample monetary liquidity would be supplied providing a tailwind for markets to continue to climb. China would answer any domestic slowdown with stimulus, helping to keep global growth on track.

Now, these key assumptions and relationships are in question. The final destination of transitory inflation remains in flux, casting central bank policy into tightening mode in some geographies and uncertainty in the U.S. and Europe. Unprecedented amounts of liquidity are starting to slowly drain from the financial system, creating risks for market participants that have been reaching for yield. China’s reluctance to inject stimulus into its flagging economy may create waves in global growth projections.

Heading into 2022, core fixed income is already on track to post negative yearly returns for only the fourth time since 1976.1 The weakening of these key relationships is creating new challenges for an already challenged asset class.

Inflation raises central bank uncertainty

The market’s trust in a patient pace of rate normalization by central banks has been upended by increasing evidence of “sticky” inflation. A surge in front-end rate expectations reflects that many are reevaluating the thesis that inflation pressures are “transitory” (Figure 1).

Figure 1: Breaking bonds,1-year forward rate expectations

1-year forward rate expectations

Our previous commentary, Tempting FAIT, described the risk of moving from a “demand-pull” inflationary environment to a “cost-push” environment. Demand-pull inflation is typically short-lived as the supply side catches up and demand eventually normalizes. Cost-push, on the other hand, can result in more sticky inflation when high goods and services costs result in workers demanding higher wages, and with higher wages feeding back to higher input costs.

As global economies reopened in the beginning of the year, inflation reflected the combined forces of a surge in demand with a significant disruption in supply. The most recent inflation reports highlight spreading inflation pressures into key areas associated with sticky rather than transitory inflation in rent, wages, and passthrough sale price increases from higher input costs. Trimmed measures of inflation, which look at broad measures and discount outlier spikes in a single category, no longer look contained. Inflation is broadening and has surged well past 2%, leading to more concerns over a cost-push inflation cycle.

Adding pressure to this issue, the recent spike in global energy prices results in more purchasing power getting siphoned off into energy consumption. When rising inflation outstrips consumers nominal earnings growth, the real value of income falls. So, despite having seen strong consumption contribution to growth so far, a more persistent inflation that erodes the purchasing power of the consumer can undermine the outlook for real growth.

Going into the end of 2022, the outlook for prolonged energy costs may hinge on the forecast for the weather. An exceptionally cold winter in the northern hemisphere could bring natural gas prices even further beyond the stratospheric increases already seen—with knock-on effects for consumers and producers across the global economy.

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Originally Posted on November 12, 2021 – Breaking Bonds

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1. Source: Bloomberg, as measured by the backfilled history of the Bloomberg Barclays U.S. Aggregate Bond Index. Year-to-date 2021 returns as of 10/31/21. 

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