Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Macro Insights: Inflating inflation fears
Charu Chanana
Chief Investment Strategist
Summary: Markets have been spooked recently by higher US inflation reinforcing the higher-for-longer interest rates rhetoric. Inflation risks continue to point towards further acceleration despite the easing of supply chain disruptions, mostly driven by services cost pressures underpinned by high wages. China’s reopening and the no-landing narrative will also bring fears of an additional inflationary impulse, along with structural issues of deglobalization and energy crunch.
Broader expectations last year were inflation will fall back towards target in 2023, allowing central banks to cool down their pace of policy tightening. We have been in the inflation higher-for-longer camp since the days it has been called “transitory”, and a rude awakening for the markets is happening now bringing inflation expectations higher. January inflation data for the US and the Eurozone came in hot, fueling bets that central banks will have to do more to bring prices under control. Meanwhile, wages remain high due to the demand/supply imbalance in labor market further aggravating inflation concerns.
US inflation concerns aggravate
Fed’s preferred inflation gauge, the PCE deflator, came in hotter-than-expected for January. In addition, upward revisions to the previous month’s prints sent a strong hawkish signal to the markets reinforcing the Fed’s higher-for-longer message. Core PCE rose 4.7% YoY, accelerating from the upwardly revised 4.6% and above the expected 4.3% and the Fed’s target of 2%. The MoM rose 0.6%, hotter-than-expected and upwardly revised prior of 0.4%. This comes on top of a hot January CPI as well as PPI, all together underscoring persistent inflationary pressures and the need for the Fed to continue hiking rates.
Supply chain disruptions easing, but risks won’t go away
The cost of shopping containers have retreated from the covid-era peaks. Spot rates from Asia to the US West Coast, which increased more than 15-fold during the pandemic, have since returned to pre-Covid levels. Still, prices remain significantly higher that the pre-covid times, such as the short-term prices for containers from Europe to the US East Coast are still more than double what they were in late-2019.
More importantly, risks remain elevated amid a rapidly deglobalizing world. The geopolitical tensions never went away since the year-ago Russian invasion of Ukraine, but have accelerated meaningfully again the last few weeks as we approached the one-year anniversary of the war. Alongside, rising tensions over Taiwan and the US-China relations have become an increasing focus. So even if spot prices in shipping are easing, the contracts have been renegotiated at higher prices in 2021 and 2022 at much higher rates, and the potential for discount remains limited for now given the high risk environment. That is a key reason why the disinflation in goods prices, which was highlighted by Chair Powell at the February FOMC, has quickly reversed and remains volatile at best. It’s hard to get comfortable about the trend in goods inflation, let alone the surging services inflation.
Wage pressures are a key concern
Despite widespread news of tech layoffs, the January jobs growth of +517k sent a shockwave to the markets. Unemployment rate touched a 53-year low as service providers expanded their activities. Likewise, jobless claims data and surveys on unemployment all continue to point at hiring and wages would remain on an upward path.
With the demand and supply imbalance in the labor markets continuing, companies are feeling wage pressures eat into their margins. As the US consumer is still holding up well even in the wake of high inflation and interest rates, companies with pricing power will pass on these wage costs to the consumers, thereby creating more upside pressures to inflation and a potential wage-price spiral.
Re-acceleration of cyclical growth
Transition from a recession to a goldilocks/soft-landing narrative to the current no-landing/acceleration narrative isn’t all positive for the markets. The Atlanta Fed GDPNow model estimate for real GDP growth in Q1 is now at 2.7% from 0.7%, which is hardly a sign of recession or stagnation.
Overall, recent economic data suggests that the US economy is reheating, and the market is moving to price that in by bringing the terminal rate forecast higher and driving out the rate cuts priced in for this year to 2024. This also brings back the risk of higher inflation. The reopening of the Chinese economy also brings fears of an inflationary impulse through commodity and raw material prices.
Cleveland Fed economists Randal Verbrugge and Saeed Zaman have said that it will likely take US inflation many more years than central bankers and financial markets expect to close in on 2% without a deep recession.
Upward repricing of the Fed path
Beyond cyclical risks, inflation continues to face upside threat from structural factors such as shortage of labor, deglobalization as well as the energy supply crunch. US breakevens are signalling renewed concern that inflation will stay elevated in the shorter term, with the 2-year rate above 3% for the first time since August 2022 and the 10-year rate holding at around 2.5%.
As such, market expectations of the Fed path have seen a dramatic shift from expecting a pause/pivot to now pricing in a terminal rate of 5.4% from sub-5% a month back. Calls for 6-7% terminal rates have also picked up. But the Fed has already transitioned to a 25bps rate hike pace, and it would potentially be a credibility issue if they were to move back to 50bps rate hike increments. So, a longer tightening cycle looks like the most likely outcome.
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