Global Head of Fixed Income Jim Cielinski explains why inflation remains the hinge point for fixed income and weighs in on five key questions for investors.
- Have we seen the worst of the rates sell-off?
- Are we about to swap inflation fears for growth fears?
- Do central banks care if they provoke a recession?
- Does synchronized tightening have implications for markets?
- Is fixed income back on investors’ radars?
Have we seen the worst of the rates sell-off?
Jim Cielinski: The sell-off in rates and in bonds has been truly extraordinary this year, the worst on record, in fact. And total returns from bonds in many markets have been deeply negative. Now, when you're looking forward though, you have to ask, “will this persist”? And I'd have to say “no.” That does not necessarily mean that rates have peaked, but it does mean that we've now priced in a very aggressive central bank response. And then the inflation premium has started to moderate somewhat, expecting that inflation may be still too high, but it will roll over. And I think as this happens, there's a good chance that we will see some peaking in rates. But again as we've been saying, it's all down to inflation, inflation, inflation. If inflation persists, I think rising rates will continue to be a risk.
Are we about to swap inflation fears for growth fears?
As inflation has picked up and as central banks and policy has gotten tighter, it's created concerns about growth as well, and it's prompting many to ask whether growth fears now replace inflation fears? And I'm afraid it's not that simple. I think you now have both inflation fears and growth fears.
Inflation is a lagging indicator. There are some early signs that it's rolling over, and, as it does that, growth is also beginning to slow. But as a result, I think what you have is an increase in stagflation fears and I think it's going to take most of the year to see this play out. Growth and inflation, I think, by year end, will both be lower than they are today.
Do central banks care if they provoke a recession?
I think what they're telling you is not that a recession is a desirable outcome; what they are saying quite clearly, I think, is that if it takes a mild recession to tame inflation, that's the price that we're going to have to pay.
Inflation is their primary remit in most cases. In some cases, like the U.S., it's also about full employment. But we have full employment, and we have inflation that is way too high, so I think central banks know they have to correct that. They don't want a recession, but they will risk it, if that's what it takes. This is a big deal because we're used to a Fed where a central bank “put” – if markets get too bad or if growth gets too weak – they're going to step in and rescue the economy. We now have the opposite. And in fact, you're not long the put anymore, you're actually short the put as an investor. They're telling you that they're going to keep forcing things tighter until things break. And by break, they mean lower asset prices.
Does synchronized tightening have implications for markets?
Like many cycles, economies move together. And with that, so does policy. Inflation is too high in most regions so central banks are all tightening together. Some are beginning to move into quantitative tightening. And it's often through these synchronized steps that you see a building effect, which makes it difficult for policymakers to get it right. I do think this is what we are going to have to watch in the coming year.
Not every economy is doing the same thing. China for example, is already in easing mode. So, not everything is synchronized globally. But right now we have a real issue in developed markets that central banks have to tighten. They have to get tighter. And as they do that together, it makes it much more difficult to predict the aftershocks.
Is fixed income back on investors’ radars?
So, what is an investor supposed to do with fixed income? It’s an entirely different landscape than it was six months ago. I would start by making sure you don't look in the rearview mirror, look forward. The yields today give you return potential that just did not exist a short time ago.
Markets have adjusted with one of the deepest sell-offs ever in bonds, but that leaves you with valuations that now allow bonds to be a much better diversifier. It leaves bonds in a position that, if there was any retreat in inflation or retreat by central banks on their very hawkish policy paths, that you can get some decent price appreciation from the bond market. So, I think for me, it's about inflation once again. That determines policy and ultimately probably determines whether we go into recession or not. And that's important because asset classes like credit, high yield, investment grade, are dependent upon growth. Keep an eye on inflation, on the path of policy, and remember that diversification – particularly at these elevated yields – can actually play a key role in your portfolios.
Central bank policy/monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Easing refers to a central bank increasing the supply of money and lowering borrowing costs. Tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fed: The U.S. Federal Reserve, the central bank of the United States of America.
Fed put: The market belief that the Fed would step in and implement policies to limit the stock market's decline beyond a certain threshold.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Quantitative tightening: When a central bank shrinks its balance sheet and the money supply by either not reinvesting the maturing securities it holds on its balance sheet or actively selling them.
Rates: A marketplace for investment in government bonds and associated derivatives.
Stagflation: A relatively rare situation where rising inflation coincides with anemic economic growth.
Yields: The level of income on a security, typically expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price.