Investor Sentiment: Adjusting to More Stubborn Inflation

Q4 Flows and Holdings

The swarming kettle of hawks

Monetary authorities finally called “no mas” to the inflation threat, with several developed market (DM) central banks raising rates or signaling that rate hikes are coming soon. This comes as no surprise to emerging market (EM) bankers who tightened financial conditions for the better part of 2021, even as their larger counterparts espoused the belief that surging prices were temporary. While we think that many still view supply chain and energy induced inflation as transitory, more problematic structural concerns have emerged in wages, services and shelter costs. Our PriceStats® readings on inflation show just how stubborn higher prices have become, with DM inflation near 4% and EM inflation more than 15% (see figure 2 in PriceStats).

While not alone, the US Federal Reserve’s (Fed’s) hawkish pivot was notable in how quickly it shifted gears toward rate hikes. Although it was considered one of the most dovish central banks in our MKT MediaStats sentiment index just six months ago, the market now expects six US rate hikes over the next two years. For the Fed, the past quarter has included the start of the taper process, an acceleration of the taper schedule and strong signals that it will start raising rates in mid-2022. Not to be outdone, the Bank of England and Norges Bank both raised rates in the fourth quarter, with signals that the normalization process will continue in 2022. There were a few holdouts, however, as the European Central Bank (ECB) and Bank of Japan (BOJ) continue to sound uber-dovish. Overall, we added 400 basis points into 2022 G-10 rate hike expectations in the fourth quarter, with all but the BOJ expected to roll out some form of tightening this year.¹

Despite the general agreement that hikes are coming, the dispersion in views on where rates settle has never been wider. Therefore, we may see aggressive hikes from the likes of the Fed, Bank of Canada, Norges Bank and the Reserve Bank of New Zealand this year, but hardly a peep from the ECB, BOJ, Riksbank and the Swiss National Bank. Longer term, expectations are that hikes will be shallow and most likely fall short of prior rate normalization cycles. While this would generally be supportive of risk assets, the potential for a rapid upwind of rate cuts raises the specter that central banks will begin to normalize balance sheets, which proved problematic the last time the Fed embarked on quantitative tightening.

These crosscurrents have left the markets in a precarious position, and we have seen investor behavior recently turn negative across the rate markets, with our shorter-term indicators pointing at selling across both DM and EM. Demand for Treasury Inflation-Protected Securities (TIPS) nonetheless remains strong, indicating continued inflation concerns even as longer-term expectations remain well anchored. Constructing a soft landing has never been easy for central bankers and, for the moment, investors are cautiously approaching fixed income assets.

Safety first for Treasuries

Demand for US Treasuries has waned as the Fed has repeatedly turned more hawkish, first by accelerating the taper timeline and then by signaling the potential for three rate hikes in 2022. Inflation, which the Fed no longer describes as transitory, was largely behind this rapid change in outlook and remains the top market risk for many investors. It’s therefore no surprise that demand for inflation-protected securities remains in the top quartile, even as overall Treasury demand fell below neutral. A closer look at our Treasury flows shows that robust demand continues at the belly of the curve, an indication that overall rate hikes may prove shorter and shallower than expected. At the same time, buying has waned longer out the curve, which when combined with TIPS demand indicates that we are not out of the inflation woods just yet, even as the Fed is signaling a willingness to try to contain prices. If these crosscurrents seem at odds with each other at times, it’s just a sign of the challenging economic environment that greets us in 2022.

Surging Demand for TIPS

Safety first for sovereign bonds

Emerging market investors faced a formidable wall of worry in 2021, with uneven vaccination schedules and surging inflation high on the list of concerns. With another year of negative currency returns eroding much of the yield advantage offered by local currency bonds, investors notably favored developed market sovereigns for the better part of 2021. As the chart indicates, our flows show that real money investors have been net sellers of EM local currency bonds relative to benchmarks since last spring, a trend that continued into year end. And while positioning has fallen to neutral, many of the concerns that challenged EM in 2021 carry into the new year. In particular, inflation remains an ongoing headwind, despite 25 percentage points of rate hikes across the EM complex. The hawkish pivot from DM central banks has notably eroded buying in those markets, with rate hikes in 2022 now expected across much of the G-10. This has nonetheless narrowed the yield advantage enjoyed by EM sovereigns, which may be further challenged if overall tighter financial conditions drive market volatility. For the moment, it seems that investors will continue to favor the safety of the DM over EM debt markets.

EM Local Sell-Off Continues

Reaching for corporate yield

While global rates saw their most significant repricing since the 2013 taper tantrum, absolute yields nonetheless remained near their all-time lows. This has created a reach for yield across spread products, particularly corporate bonds, which saw spreads compress to their lowest recorded levels this past summer. Low funding costs ultimately drew a plethora of issuers to the primary market, with high yield sales setting a record, while investment-grade bonds were just behind 2020’s record sales. Spreads and overall yields buckled under the weight of all this issuance, and real money flows were underweight for much of the fall. More recently, we have seen investors again reach for yield, with a reversal of selling in both high yield and investment-grade sectors, pushing our 20-day moving averages back toward their summer highs. Given that high yield was one of the few fixed income sectors to report positive gains last year, we suspect that this demand will continue as long as Treasury yields remain contained.

Investors Reaching for Yield