Wall Street’s Great Inflation Trade Peaks as Funds Dump TIPS

(Bloomberg) -- The great inflation trade on Wall Street has reached a tentative peak, judging by a slew of cross-asset signals including the world of passive money.

Investors have pulled cash out of the largest exchange-traded fund tracking Treasury Inflation Protected Securities at the fastest clip since March. That’s just as Bank of America Corp. clients with $1.1 trillion say the price outlook is now the weakest in more than a decade.  

In the monthly poll of 329 panelists, a net 48% forecast lower inflation from here -- the most since 2009. The sanguine outlook mirrors bond-market projections of easing price pressures, even as the spreading omicron variant causes new havoc in global supply chains.

After stockpiling hedges for the past year, the hottest U.S. inflation print in almost 40 years is spurring a slew of traders to pare exposures to what’s become a crowded trade fighting last year’s battle. 

“If you just look at what the bond market’s priced in in terms of inflation for the medium to longer term, inflation moderates,” said Jason Draho, head of asset allocation Americas at UBS Global Wealth Management, who favors value stocks and commodities tied to rebounding global growth. TIPS “should underperform when real rates rise, which is what we expect for this year.”

Consumer prices that surged 7% in 2021 have a long way to go before they slow to the Federal Reserve’s target of 2%. But according to the latest BofA survey, the danger is now easing.

“Investors expect inflation, not growth, to fall in 2022,” BofA strategists led by Michael Hartnett wrote in a note Tuesday. More than half of clients polled said inflation is “transitory.”

Investors have withdrawn about $440 million from the $37.5 billion inflation-protected bond TIPS ETF so far in 2022, the biggest two-week outflow since March. That contrasts with a record inflow of $12.1 billion in 2021. And similar products such as the Vanguard Short-Term Inflation-Protected Securities Index Fund have continued to lure cash this year.

Covid-related supply bottlenecks and a tight job market are seen my many as short-lived factors behind the current surge in prices. With life returning to a tenative normal in the U.S., these pressures should abate, the thinking goes. 

The Fed has also vowed to curb the latest bout: Chair Jerome Powell told a Senate committee last week the central bank will use its tools “to prevent higher inflation from becoming entrenched.”

Mark Nash, head of fixed income alternatives at Jupiter Asset Management, said TIPS hold little appeal in an environment of rising rates, despite their ability to protect against price erosion. 

“We have been avoiding TIPS since November,” he said. “We still expect the Fed to raise interest rates. We are underweight duration and TIPS have it. Their real yields are also too low.”

JPMorgan Chase & Co expects price growth to stay elevated at the pace of around 3.5% over the next two years before easing. The bank recommends hedges other than inflation-protected securities, citing their low yields.

“The peak in inflation is behind us,” said Nikolaos Panigirtzoglou, a strategist at JPMorgan. “This market inflation expectations look reasonable as the central bank tightening over the next two years should help to lower inflation after 2023.”

At HSBC Holdings Plc, head of fixed income research Steve Major is underweight long-dated 30-year TIPS and is prepared to move that to shorter maturities once it’s clear inflation has peaked.

“We think it highly unlikely that the Fed’s tightening path will be smooth and without interruption, but it at least should help contain inflation expectations,” Major said. “Once we have a trend of falling inflation, depending on the context, it is likely we would move this underweight TIPS view to the 10-year.”

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