• Wealth Professional

Wealth Professional | Mar 16, 2021

Investors should be braced for a volatile bond market in 2021 as nervousness around inflation tests the resolve of central banks to get the economy motoring, according to one fixed income manager.

Brian D’Costa, founding partner at Algonquin Capital, told WP it promises to be an exciting time for fixed income in light of the differing opinions around the prospects of eventual rate hikes and higher inflation.

Ultimately, though, D’Costa said it always comes down to the balance of risk. The base case, of course, is that central banks will keep rates low into 2023 but the question is: will the process of returning people to work happen slower or faster than they think? With the majority of the affected jobs in the service industry, many believe employment growth will be faster than originally anticipated.

He said: “If that turns out, then the central banks will need to shift their timeline for raising rates not from 2023 to 2024 but from 2023 into 2022 – and that’s the risk in the bond market.

“Right now, the two most important economic data points are going to be the employment numbers and, to a lesser degree, inflation. Central banks have been clear that they expect to see inflation numbers above 2%. They believe it’s temporary, so they’re not going to be terribly fussed about it and I think that’s the right approach, actually.

“They won’t fret about whether we get 2.5% inflation for a few months in a row – it’s not a big deal. To me, the real story here is how fast will employment come back. If that does prove to be more resilient than the central bank base case, then you’ll see them reducing or eliminating forward guidance, which will get the front end rates moving because people will start to place bets on an earlier rate hike.”

D’Costa’s own view is that rate hikes will begin in late 2022. In the meantime, there promises to be tension as inflation rises – with central banks undeterred but the bond market likely struggling to contain its concern it might get out of hand because of the amount of stimulus in the economy.

For those playing in the bond market, especially those in sovereign bonds, if inflation heads past 2%, it’s no longer a “zero probability” it will revert back to that 2% average number. Traditional economic theory suggests that overstimulating the economy can lead to inflation, so there is naturally some percentage chance that it keeps going up into the 3-4% range.

D’Costa added: “This is where central bankers are really going to be tested and the bond market is going to be volatile because the nervousness of bond investors will challenge the resolve of the central bankers to look through higher inflation numbers.”

This approach will be validated if unemployment numbers rates drop slowly allowing investors time to assess that a rise in inflation is a temporary phenomenon. However, if those inflation numbers are around 3% and, for example, the U.S. is creating a million jobs a month, there will be an argument that the Federal Reserve has to act on interest rates sooner rather than later.

D’Costa said: “It’s going to be an exciting bond market this year, because there will be a difference of opinion and we’ll see some large ranges in expectations for interest rate movements. On top of that, yields are being suppressed to some degree by quantitative easing. Added to the headache for the central banks is, how do you manage tapering?

“The taper tantrum of 2013 was an ugly move. I don’t expect [a repeat] necessarily, however if you’re seeing higher inflation numbers, stronger employment numbers, and central banks start tapering, the bond market’s probably going to have a few bad days in there.”

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