A just-published report pointed out that major central banks will soon shift to a more moderate pace of hikes notwithstanding Fed Chairman’s Powell’s press conference caveats. In the near-term bonds remain oversold and have moved in lockstep with expected policy rates, such that the risks to G7 government bond yields are to the upside. While bond yields are following the Fed’s lead, we still expect a positive total return on bonds on a 6-12 month horizon, albeit subject to elevated volatility and disappointing in real terms.
While both the Fed and ECB are likely to pause next year, it is premature to price in rate cuts thereafter, because we believe inflation will prove stickier than expected. Furthermore, markets remain overly sanguine about longer term inflation. The U.S. 5-year, 5-year forward CPI swap rate is a sedate 2.6%. This metric captures demand for inflation compensation beyond the current cycle, and such a low rate implicitly assumes that the Fed will achieve its 2% PCE inflation target over the longer term. We believe that this is unduly optimistic given the unwinding structural forces that have propelled disinflation in recent decades, as well as the already-elevated U.S. dollar.