Eyes on inflation
Central banks, including the Reserve Bank of Australia, have reinforced commitments to QE and ultra-low official rates for the foreseeable future. However, in 2021 theoretical discussions about inflation risk have turned into somewhat louder rumblings, leading investors at least to consider what central-bank policy tapering might herald.
Australian Commonwealth government bond (ACGB) and other government bond yields have inexorably marched higher since the beginning of 2021 – the 10-year by around 70 basis points from early January to late February. Furthermore, as of late February the overnight indexed-swap curve was predicting a cash-rate increase to 0.25 per cent in late 2022.
There are multiple drivers, including the exposure of long-end rates to global central-bank policy and positive COVID-19 vaccine news since the end of 2020 putting a tailwind behind global economic recovery.
One hypothesis gaining momentum is that the quantum of stimulus injected into the global system over the last 12 months, combined with reopening of economies, could cause an inflation shock and possibly lead to central banks raising interest rates or tapering QE programmes sooner than expected at the start of 2021.
Australian major-bank strategists are pouring cold water on the idea that inflation could rudely outstrip expectations and force the hands of central banks.
Fund managers seem to agree. Tim Hext, portfolio manager at Pendal, cites 2013 market expectations that the US Federal Reserve would hike several times as comparable. The Fed was unable to hike at all in 2013.
“It is fair enough that some in the market are concerned about inflation but it is hard to see the conditions where inflation runs sustainably above the RBA target. It is probably correct that inflation creeps higher in the near term, possibly briefly hitting 2.5 per cent underlying as commodity prices rise. It is just hard to see it sustainably at that level,” Hext says.
For inflation to shock an economy, surging demand must catch supply by surprise. Hext says the last time this occurred in Australia was 15 years ago, when mining investment began to boom after a long period of public and private underinvestment. The environment is very different in 2021.
Another key component of investor confidence is that QE has not been successfully exited anywhere it has been tried. Once deployed, the temptation to keep using QE as a market tamer is strong – and so far this has not led to runaway inflation.
Chris Rands, portfolio manager, fixed income at Nikko Asset Management in Sydney, says while the major central banks maintain their policies, the RBA likely has little choice but to join them. “As long as monetary-policy conditions remain easy, we are comfortable with the rates environment,” he says.
It is clear, though, that volatility is likely to be an ongoing or at least a recurring feature of markets as central banks confront the paradox of maintaining extremely loose monetary policy while economies rebound strongly.
Pauline Chrystal, portfolio manager at Kapstream Capital, says the environment is leading to caution. “We are seeing tight valuations in an economy that is still reliant on fiscal stimulus and where markets are reliant on QE. We are protecting the portfolio and building up cash instead of chasing yield. Strong technicals mean issuers are able to go for longer tenors, but this brings a lot of risk if another sell-off event occurs.”
Rands adds that with credit spreads tight and curves steep it is a challenge to work out which allocations make most sense. But he also says signals are emerging that could indicate how various sectors will perform from here.