Global Bond Investors Are Betting Against Central Banks’ Aggressive Tactics
(Bloomberg) -- Global bond investors are betting against the increasingly aggressive tactics taken by central banks in the chase for economic growth, by turning to strategies that profit when inflation fails to pick up.
In the options market, trades that make money if inflation drops below 1% -- and even below 0% -- have increased. Money managers are buying into government debt, undeterred by negative yields. They are also holding cash, which offers flexibility in the event of economic contraction. A U.S. factory gauge hitting its weakest level since the end of the last recession suggested that might be coming sooner, rather than later.
These so-called deflation trades may prove even more popular around one of the first major set-piece data releases of the fourth quarter: Friday’s U.S. jobs report. That could set an uneasy tone for markets into the latter part of the year, with no shortage of risk factors ahead. Just Tuesday, data showed a slowdown in euro-area inflation and the first drop in consumer prices in South Korea.
“The first sign of a change in the labor market, we and the market are going to scream recession,” said Russell Silberston, a money manager at Investec Asset Management, which is overweight cash. “We are running very light risk because the path is so unclear.”
In Europe, a gauge of where markets expect the pace of price rises to be in up to a decade’s time -- the five-year, five-year inflation swap rate -- slumped to 1.16%. That leaves it just above the record low of 1.13% seen earlier this year and well short of the European Central Bank’s goal of inflation running close-to, but below 2%. Inflation data for the region in the year through September disappointed, dropping below 1% for the first time since 2016.
In the U.S., inflation expectations as measured by 10-year break-evens touched the lowest levels since 2016 on Monday. Treasuries reversed earlier losses Tuesday after the Institute for Supply Management’s factory index slipped to 47.8 in September, the lowest since June 2009. Ten-year yields at 1.64% are over 100 basis points below where they were at the start of the year.
A forecast issued Monday from Fitch Ratings that global growth will hit an eight-year low in 2020 also pointed to a lack of traction for economies around the world. It came after some of the loudest doubts about the ability of monetary policy were voiced by top-level policy makers and politicians, adding to their resonance.
Mario Draghi, the outgoing president of the European Central Bank, led calls for fiscal stimulus in Europe. Across the Atlantic, sustained criticism of Jerome Powell, chairman of the Federal Reserve, has come from U.S. President Donald Trump.
A range of markets that gauge expectations for inflation -- which usually needs economic growth in order to last -- have tracked the dwindling level of faith in the outlook for the return of rising prices. If correct, the consequences for a range of current valuations for growth-sensitive assets across global markets could prove seismic.
After a mixed run of numbers in Europe, Friday’s U.S. jobs data may set a clearer direction. While German joblessness fell unexpectedly Monday, inflation data there and from Spain missed forecasts. The ISM’s employment measure dropped to the lowest level since January 2016.
Ahead of the Labor Department’s set-piece release, economists surveyed by Bloomberg expect to see the creation of 147,000 jobs in the U.S. outside the agricultural sector in September. The unemployment rate is expected to hold at 3.7%, while year-on-year average hourly earnings growth rate is also forecast to be flat, at 3.2%.
Commerzbank AG identifies a deepening sense of pessimism. “The ongoing pressure on inflation break-evens in both euro and dollar shows signs of switching from lowflation to deflation hedging,” said Michael Leister, head of rates strategy at the German bank. “If you benchmark break-evens against the central bank easing and oil dynamics, it’s very sobering.”
Hopes that the slowdown in the first half of the year was just temporary are rapidly evaporating as economic data slows and global trade tensions show no sign of easing. By most accounts, German manufacturing -- a key driver of the region’s economy -- is already in recession, while there are signs it is spreading to services and the wider region.
Elevated recession risk
Pacific Investment Management Co. stops short of pointing to a global economic contraction as its base case, but it, too, is cautious. “You do have elevated recession risk, you do have the potential for a grab for duration,” Andrew Balls, chief investment officer for global fixed income, told Bloomberg TV. “We don’t want to have big underweights here.”
Citigroup Inc. is recommending investors short inflation, via inflation swaps, targeting a drop to 1%, calling the ECB’s efforts to revive expectations “futile.”
There’s been “more bad data, falling inflation expectations, ECB resignations and unwanted tightening,” wrote Citi strategists including Jamie Searle in a note to clients. It’s “hardly an auspicious start for an ECB package designed to re-anchor inflation expectations closer to target.”
Should central banks show less willingness to pump in stimulus, that may only add to deflation worries.
Aviva Global Investors is taking a cautious approach to the U.S., buying 30-year real yields via inflation-protected Treasuries as a hedge against a global recession. They’re still positive, unlike similar-dated ones in Europe, and offer much-sought-after duration.
“It’s hard to see that the stimulus so far has been enough to do the job,” said Joubeen Hurren, a money manager at Aviva.
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