Now is a good time to add duration to portfolios
The disinflation process has begun. After the record levels reached in 2022 in the USA, the UK and the Eurozone, headline inflation (which includes the prices of food and energy) has been moving lower at a rather steady pace. As an illustration, inflation in the Eurozone has been estimated to be 6.9% over the past 12 months in March, down from 10.6% back in late 2022. However, this pleasing dynamic must be put into perspective: if inflation is falling, it is because of what is known as a base effect. Prices are not falling, but the pace of price increases is somewhat slower than at the same time a year ago.
This "mechanical" slowdown might seem like good news, but it is far from enough as core inflation, which excludes the prices of food and energy and focuses on goods and services, is deemed to be a better indicator of domestically generated inflation and is still too high. This underlying measure of inflation remains close to its highest point of the cycle in the UK and has not stopped accelerating in the Eurozone. It had slowed in the US because of lower goods prices, as Covid-related inflation has vanished, but the prices of services (especially excluding housing, which has become a key indicator for the Federal Reserve) stands at 5.5%, marginally down from 6.6% back in September 2022.
Despite inflation being stubbornly high, economists expect a sharp slowdown of inflation over 2023 : the consensus is that US inflation should reach 3% by the end of the summer, just above the Federal Reserve target of 2%, and that Eurozone inflation should not reach close to 3% until late 2023.
Similarly, inflation breakevens (which reflect the average annual inflation priced into inflation linked bonds) also show that in the US inflation is expected to average 2.4% per year over the next decade, only a touch lower than what is seen in the Euro Area at 2.6%.
The bond market is signaling tight monetary conditions which may signal that now is a good time to add duration. Indeed, as banks tend to borrow over the short term to lend over longer horizons, an inverted yield curve has generally been associated with slower credit growth and has therefore become a key indicator of when interest rates reach their peak. The recent turmoil in the banking sector, coupled with the inversion of the US Treasuries curve since November last year, is likely to trigger a pause in the Federal Reserve’s rate hikes before summer. Historically, such a pause has also been a bullish duration signal.
With this in mind, we believe that it may be appropriate to add duration to portfolios now, as a strategy for the economic cycle. However, as there is a risk that inflation will remain high, we also believe that it is better to implement long duration positions through inflation-linked bonds.
As inflation-linked bonds are issued by sovereigns, they tend to be liquid and highly rated. On top of this, the tightening of monetary policy over the past 18 months has brought inflation-linked bonds yields, also called real yields which is the premium earned by investors on top of future inflation, at their highest level since 2009 or 2010, depending on the maturities.
Inflation breakevens are currently inexpensive as the market is only putting a small premium on future inflation over Central Banks targets, we see a compelling risk / reward in the inflation linked bonds market.
With real yields now in significantly positive territory and inflation breakevens pricing a benign inflation outlook, we believe this could presents a favorable context for US, UK and Eurozone inflation linked bonds.