It has become clear that the current inflation pressures are not simply transitory. Supply-side disruptions have proven more persistent, while labour shortages could take many months to improve. ‘Transitory’ inflation looks likely to last 12 to 24 months. This could be long enough to dislodge inflation expectations.
This is an abridged version of our latest fixed income outlook
US inflation is becoming more persistent. This should convince the Federal Reserve that from September 2022, policy rate rises are warranted at a pace of 25bp per policy meeting. For longer maturities, that means the argument for pricing any inflation or real yield risk premia is weak.
Our 2021 year-end target for the 10-year Treasury yield is 1.75%, and 1.90% by the end of Q1 2022. We are underweight duration in 5-year Treasuries. We believe the longer-run fair value for 10-year BEIs (breakeven inflation) is likely at around 2.30%, but current inflation concerns are motivating steady inflows that will keep BEIs at between 2.50% and 2.75%. We are positioned flat BEIs.
In the eurozone, it is likely that shorter-dated real yields and BEI rates will remain well supported in Q4. Our view is longer-term inflation expectations will be contained. As such, we have a yield curve steepener and a small short position in BEI at the longer end of the curve.
In terms of duration risks, investment flows from the Next Generation EU funds and individual countries’ recovery plans will likely keep growth at above the long-term trend for the coming quarters. However, rising inflation expectations and higher input costs might cut into corporate profits and consumers’ disposable incomes, creating significant downside risks to growth and capping the upside for yields.
Developed market corporate bond spreads have remained low and we do not expect them to widen meaningfully in the months ahead as investors greatly favour corporate credit over sovereign bonds. Challenging valuations leave little room for further tightening, but the outlook for credit quality has if anything improved given the latest company earnings results.
We are neutral to negative on duration for Europe and the US given the outlook for higher interest rates. We prefer cyclicals as the growth outlook looks positive. A greater company focus on spending and growth might benefit shareholders, but not so much credit spreads. We are focused on tactical valuations amid a greater dispersion of returns.
In emerging markets, the upward pressure on inflation has forced some central banks to raise rates and most of the others are now at the end of their cutting cycle. While this is a headwind for EM rates, we believe there are selective opportunities in high yielders. Asia high-yield in particular has become appealing after flight-to-quality spread widening.