Cooler Heads Prevail as U.S. Inflation Fears Ease From Highs

Investors aren’t yet abandoning the view that inflation pressures will pass, even after the sticker-shock of the U.S. consumer prices report sent tremors across a broad range of assets.

Market gauges of inflation expectations pulled back from initial spikes following the data, which showed the biggest monthly increase in core CPI since 1982. U.S. Treasury long-end yields have pulled back well shy of their year-to-date peaks. And U.S. equity indexes snapped three straight days of losses Thursday.

Cooler Heads Prevail as U.S. Inflation Fears Ease From Highs

This moderation in market moves should reassure policy makers, who maintain that the acceleration in prices is temporary, due largely to supply bottlenecks as producers struggle to catch up with rebounding demand after the pandemic forced so much global activity to shut down.

“It is not a question of whether inflation will normalize but when,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “The pre-pandemic secular trends like globalization, technological efficiencies, demographics should push inflation lower, but how long these distortions continue to push inflation higher is unclear.”

Cooler Heads Prevail as U.S. Inflation Fears Ease From Highs

Getting their call right on inflation is make or break for investors. Rising costs of living erode the value of their already low-yielding assets over time, and could force central banks to raise interest rates sooner than they’ve led markets to believe.

The run-up in prices of real assets, from commodities to housing, highlights the need to have sturdy inflation hedges in place, according to Thomas Poullaouec, head of multi-asset solutions for the Asia-Pacific region at T. Rowe Price.

“What they’re telling us is that there are different signs to suggest that higher inflation for longer than the market is pricing is a risk, and we definitely shouldn’t underestimate it,” he said.

Poullaouec this year shifted to favor value stocks -- such as financials, industrials and materials and some consumer-related sectors -- over growth assets for the first time in a decade. He sees the economic recovery spurring this rotation, which he says is only half-complete.

In fixed income, he is leaning into short-term inflation-linked bonds and bank loans, or even cash, to steer clear of the sort of long-dated, low-yield assets that are most vulnerable to higher borrowing costs.

Cooler Heads Prevail as U.S. Inflation Fears Ease From Highs

Longer-term measures still don’t suggest price pressures getting out of hand. The rate on the five-year, five-year forward swap contract for CPI is still around 2.5%. Adjusted for the typical gap between CPI and the Fed’s preferred measure -- personal consumption expenditures -- that means longer-run inflation is seen running only modestly above the 2% target despite April’s extraordinary surge in price gains.

Even the bearish spike in equities bets -- reflected in the Cboe put-to-call ratio that tracks the volume of options tied to everything from single stocks to indexes -- may be a contrarian signal, according to Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.

It was likely affected by a dropoff in call purchases among retail traders, he said, noting that the S&P 500 has posted a median two-week return of around 3% following the 10 highest put-call readings over the past 12 years.

Credit Traders Bet on Central Banks Keeping Nerve Amid Inflation

Cooler Heads Prevail as U.S. Inflation Fears Ease From Highs

Yet rates markets aren’t ignoring inflation risks, which is underscored by the past month’s rise in breakeven rates, a market gauge of the inflation outlook derived from Treasury yields. The five-year rate, which is more influenced by the recent rebound in commodity prices, touched its highest level since 2005 before paring the move.

There are some lingering doubts that the Fed will be as tolerant of rising inflation as it has promised.

Eurodollars contracts are priced for roughly one 25-basis-point rate hike by the end of next year, and at least three by the end of 2023. The central bank’s latest guidance, from March, suggests policy makers see no increases over that whole period.

©2021 Bloomberg L.P.

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