As we emerge from the hard pandemic lockdowns that imposed the deepest economic contraction on record, the US economy is reopening amid a rapid COVID-19 vaccination rollout and an avalanche of fiscal spending. The big question for investors now is what kind of post-COVID economy will emerge?
In this context, one of the key questions facing fixed-income investors is whether the US economy may be heading towards higher inflation. And, if it is, will that inflation be temporary or persistent?
Will the ‘lowflation’ regime that has prevailed for the last 20 years continue? It is possible, but to assume that this is the only plausible outcome might be complacent.
In our white paper Inflation risks, regimes and implications for Treasury markets, we argue that beyond the base effects and temporary bottlenecks that are currently pushing US inflation higher, there are cyclical and structural reasons that will result in greater inflationary pressure over the next few years. Indeed, a regime shift towards persistently higher inflation looks quite likely.
What are the bond market factors to watch?
In the near term, there are concerns that the mix of large-scale fiscal and monetary stimulus could lead to the US economy overheating, and that inflation could spike higher. With the US Federal Reserve looking to generate an overshoot in inflation, the odds of that happening are good.
As the US economy reopens from the lockdowns-induced closure, the question will be when the Fed will begin to dial back on its accommodative monetary policy and reduce asset purchases with a view to returning inflation to target. Such a move could make longer-dated real and nominal yields look vulnerable in the near term.
What should investors expect on inflation?
Volatility in asset prices is likely to rise. Such trends might cause the Fed to act and tighten policy early. The volatility and rotation between growth and value stocks already shows how nervous equity investors are about higher real yields.
Trend economic growth is likely to slow further given the population (ageing) trends, but economies may well operate closer to full capacity. Heavy debt burdens mean that real yields cannot rise too much, rendering central banks the marginal buyers of government debt.
At some point, our white paper predicts, this debt monetisation will devalue currencies and fan inflationary pressures.
Read Inflation risks, regimes and implications for Treasury markets to find out what this would mean for the decades-long bull market in government bonds.
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