Worried about inflation "backfire", "smart money" quietly establishes hedge positions

Just as bond traders are becoming increasingly convinced that inflation will eventually be brought under control, a group of investors are quietly putting in place measures to guard against the risk of future price spikes.

Some fund managers are building positions to cushion fixed income returns in the event of inflation shocks. Wall Street strategists are also advising to hedge against the forecast of declining future inflation by establishing protective positions at a low cost.

This is not a consensus trade. After all, more and more data (including benign inflation data from the US and UK) indicate that after years of monetary tightening by global central banks, price pressures are easing, economic recession has replaced inflation as the main concern, and rate cuts have become a certainty. This hopeful news has led to a significant drop in benchmark bond yields. However, some believe that the market may have gone too far.

John Bilton, Head of Multi-Asset Strategy at Morgan Stanley Asset Management, said, "At current yield levels, we believe concerns about economic recession have been overdone, and inflation risks may be underestimated." Bilton stated that given "some forces that could push inflation higher," he maintains a "broadly neutral" stance on interest rate risk exposure.

While inflation has clearly slowed down from the peak of the COVID-19 pandemic, the path downwards is bumpy, and inflation in some regions has proven to be stubborn.

Strong retail sales data from July indicate that the US economy is still resilient, and a series of threats from international trade tensions and shipping disruptions to massive public spending and Middle East turmoil will only increase the upward inflation risks.

For these reasons, some investors believe it is necessary to take measures to counter a potential inflation rebound.

Marie-Anne Allier, who manages a €5.6 billion (approximately $6.2 billion) fixed income investment portfolio at Carmignac, said, "If inflation rates prove to be more robust or rise again, it could disrupt your investment portfolio if you have interest rate risk exposure."

Allier also believes that the market is too optimistic about the inflation outlook. As a hedge, she uses derivatives linked to euro and US inflation for three- and five-year periods, as well as three-year Spanish inflation-linked bonds.

Central bank governors around the world are also emphasizing the need to remain vigilant, even as they shift their focus to growth risks and signal rate cuts. At the central bank symposium held this week in Jackson Hole, Wyoming, Federal Reserve Chairman Powell and others will deliver speeches, from which investors will seek clues on how central banks are balancing inflation and growth.

Neil Sutherland, Portfolio Manager at Schroder Investment Management, said, "In the past two to three years, central banks around the world have mainly focused on inflation, but now they are shifting to the labor market and paying more attention to it." He added, "I'm not saying the battle against inflation is over, but they have done quite well in this regard." Despite this, many investors believe that the market's inflation indicators have already peaked. Taking the example of the breakeven rate of the US five-year Treasury Inflation-Protected Securities (TIPS), in recent weeks, as concerns about an economic recession have intensified, this rate has sharply declined to around 2%, the first time since 2021 (as shown in the chart below). It refers to the difference between the TIPS yield and the nominal yield of a similar term, serving as an alternative indicator of the average price increase during this period.

If the Republican presidential candidate Trump wins the US presidential election, a crisis may come soon. His campaign platform includes tax cuts, increased tariffs, and cracking down on immigration, all of which could potentially trigger inflation.

Gareth Hill, a fund manager at Royal London Asset Management Ltd., has been increasing the US inflation risk exposure in his portfolio through the five-year TIPS breakeven rate, essentially betting that the performance of the five-year TIPS will outperform similar-term nominal bonds.

Setting aside the election, Hill still sees value in this trade, believing that "the last mile of the fight against inflation is the most difficult."

Outside the US, inflation data in many developed countries remains unsettled. Australia has almost ruled out the possibility of a rate cut in the next six months, with the country's inflation rate still at 3.8%, while the eurozone's inflation rate unexpectedly accelerated in July. Barclays strategists suggest preparing for a rise in the eurozone inflation rate next year through short-term swap trades.

Even Japan, which has finally escaped decades of deflation, is causing concern for investors. Roger Hallam, Global Head of Rates at Vanguard, says the company is cautious about Japanese government bonds and UK government bonds, as the UK's core inflation rate remains at 3.3%.

In the long run, both inflation and interest rates will be higher

Looking ahead, the structural changes in the global economy in response to challenges such as climate change and aging populations, as well as increasing government deficits, suggest that inflation and interest rates may enter a higher range.

Amelie Derambure, a portfolio manager at Amundi SA, has been preparing for this outlook through long-term TIPS.

She said, "The market is right to take advantage of the anti-inflation momentum in the short term. What is more questionable is the trend in the medium to long term."

Citigroup strategists expect long-term inflation expectations to rise as the Fed begins to ease.

Simon White, a macro strategist at Bloomberg, said, "Now may not be the time to take a high-yield view, but there is a possibility that inflation will start to rise, limiting the extent of the Fed's rate cuts and causing the market's priced-in rate cut expectations to fall short, providing support for yields." And the market simply hasn't realized this."

For many, the concern now is not inflation. For example, Eva Sun-Wai of M&G Investment Company said that core commodity prices in the United States may have already fallen into deflation, and the risk of the Federal Reserve maintaining a tight policy for a long time is greater.

Others believe that long-term inflation is a risk, but they warn that given that costs may further decrease, it is not advisable to hedge too early. Erik Weisman, Chief Economist and Portfolio Manager at MFS Investment Management, believes that if a so-called hard landing occurs, the breakeven point for U.S. TIPS could shrink by as much as 100 basis points.

Martin van Vliet, Global Macro Fixed Income Strategist at Robeco, also highlighted this risk. He is considering closing a trade that has profited from a 30-year Euro inflation swap dropping from around 2.80% last September to the current 2.30%.

After the yield on TIPS plummeted due to price surges in 2022, doubts have arisen about how much protection these bonds can actually provide.

However, Tim Foster of Fidelity International said that these securities have already proven their long-term value. He pointed out that data shows that in the past 25 calendar years, the performance of 1 to 10-year TIPS has exceeded that of its nominal counterparts in 17 calendar years, and is expected to do so again in 2024 (as shown in the figure below).

He said, "The market often fails to consider the risk of rising inflation, and the likelihood of errors far exceeding expectations is greater than errors falling far below expectations. If investors become increasingly complacent about inflation, this is not the first time."