Global sovereign bond markets continue to be characterised by heightened volatility in 2022, driven by fears of out-of-control inflation and central banks being behind the curve, having to play catch up to address inflation numbers substantially above their mandated targets. The major central banks have started to diverge in their approach on how best to tackle this.
Rate hike cycle under way
In the US, for example, inflation numbers are spiralling ever higher (the recent Consumer Price Index (CPI) Year on Year number came in at 8.3%, with core CPI at 6.2% vs an annual target of 2%) and the US Federal Reserve (Fed) has elected to tackle this head on. Having already raised rates by 25bps in March this year (the first hike in the US since 2018), the Fed raised rates by a further 50bps last week, and moreover, has communicated clearly to the market that further rate hikes are to come, and will be accompanied by reductions in its balance sheet – selling bonds bought under its quantitative easing program back to the market – a policy referred to as QT, or quantitative tightening. The Fed clearly believes that these actions will serve to dampen the rampant inflation that the US is experiencing, as it sees the driver of inflation being largely domestic – hence domestic policy action can tackle it.
Contrast this with in the UK, where the Bank of England’s (BoE) Monetary Policy Committee, despite being the first of the major central banks to raise rates with a 15bps increase in December 2021, followed by 25bps increases in each of February, March and May 2022, has guided the market that policy rates may not rise significantly higher, citing both the ‘cost of living squeeze’ and imported energy price inflation being insensitive to domestic policy tightening. In addition to this, despite meeting its self-imposed 1% threshold, the BoE has elected to delay any of its own QT, even though the Retail Price Index (RPI) came in at 9% in April 2022 – vs a 3% target.
In Europe, the picture, for the moment, seems a little clearer; the European Central Bank (ECB) has undertaken a marked hawkish pivot, signalling a sooner than expected end to its own bond buying programs and has guided the market to potential rate hikes as early as July. The ECB has recognised that whilst some of the elevated inflation is due to factors beyond its immediate control (Energy price inflation, for example), forecast inflation is now likely to be above its 2% target, so there is no longer a need for the very accommodative monetary conditions – and now is the time to normalise policy. We expect this to be more formally outlined in the forthcoming ECB meeting, to be held in the Netherlands in June 2022.
This tightening in policy from the central banks (including those in Australia, Sweden and Norway – Japan being a notable exception), has seen yields rise dramatically across all markets since the turn of the year, often accompanied by flatter curves, where longer dated yields have moved by less that shorter dated yields.
This environment has been more forgiving to shorter duration funds in absolute terms, and to funds running a short duration position against benchmark in relative terms. Where funds have had positive exposure to inflation linked assets, either via real yields or on a breakeven basis (held vs an underweight in non-index linked bonds) performance has received an additional boost, as these assets reflected both higher inflation prints and higher inflation expectations. However, in some cases this pricing of future inflation has gone too far, arguably best demonstrated in UK Inflation linked assets: on a breakeven basis, UK inflation linked assets are pricing annual inflation at between 3.3% (in longer maturities) and 5% – on an ongoing basis. With a central bank target of 3% in RPI terms, coupled with a pre-announced switch from RPI to the lower CPI measure from 2030 onwards, these assets look overpriced, particularly when compared to inflation linked assets from other sovereign issuers.
So where do we go from here? Over the past week or so, the focus has started to shift from the inflation beating narrative to fears of potential recession, driven by the impact of tightening financial conditions on economic growth. Can central banks stick to their policy tightening paths, without causing a recession? Or is a recession needed in order to get inflation back under control? Is the Fed correct to tackle inflation head on, or is the path that the BoE has chosen to follow, believing that inflation will recede of its own accord, the correct policy? Either way, one thing seems certain – this heightened volatility is unlikely to abate any time soon, and in such an environment, the benefits of an actively managed portfolio are clear – we believe that opportunities abound and that the scope for outperformance relative to a passive approach is therefore magnified.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.