Increasingly, the world's biggest money managers are split over how much further inflation will retreat from the highest levels in decades. It's a debate that matters more than ever before, as bond traders ponder the end of the Federal Reserve's aggressive campaign of interest-rate hikes and wager on cuts starting within months.
On one side are firms such as Allianz Global Investors and TCW Group Inc., which say the Fed and other central banks will prevail with their rate hikes, even if it means up-ending their economies. On the other side are the likes of BlackRock Inc. and DoubleLine Group LP, which question whether policymakers are willing to throw millions out of work, or say inflation will remain elevated longer than many expect. That means it's too soon to bet on rate reductions.
The divide between investors with trillions at stake reflects just how tough monetary policy itself has become, particularly as price pressures—from the U.S. to the UK and the Eurozone—remain stubbornly high, and with readings of headline and underlying inflation sending mixed signals. Getting the call right could offer the surest shot at redemption after a punishing year for both bonds and stocks. It's a challenge that's put not only the largest firms in finance at odds, but those who work inside them, too.
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"We've had to work hard to come up with some sort of house view," said Greg Whiteley at DoubleLine, which oversees about $96 billion. "There's a significant difference of opinion within senior portfolio managers here that get together and discuss strategy."
In the end, they decided that "inflation is, in fact, going to be sticky," he said. That makes the market wrong to position for Fed rate cuts this year, and he's looking to bet on higher yields on short-term Treasuries, the maturities that are most sensitive to changing expectations for Fed policy.
Headline inflation has waned in the United States and much of Europe after soaring amid the pandemic and the war in Ukraine. The UK, however, is still logging double-digit increases, and in the Eurozone, core measures just reached a record high.
In the U.S., both sides have reason for confidence. Fed officials frequently strip out food and energy costs to ascertain longer-term trends, focusing on three main buckets: core goods, housing services, and other core services. In the first group, inflation has cratered. In the second, pressures have stayed strong, but are expected to ease.
The third bucket is more uncertain. It includes everything from healthcare to hospitality—and it hasn't weakened much. Fed Chair Jerome Powell has called it perhaps the most important category for the inflation outlook.
After the past year's rate hikes, inflation expectations have become anchored, reflecting investors' faith in the Fed in the long-term. A measure that assesses expectations for the second half of the next decade reflects around a 2.2 percent annual inflation rate for that period. So about in line with the Fed's 2 percent target.
Investors' task now is to divine how much pain central banks are willing to inflict to attain their goals, or even whether a 2 percent target still makes sense. The Fed's preferred measure of inflation is still more than double that.
Sticky Camp
At BlackRock Investment Institute, a unit of the world's biggest money manager, the view is that the Fed will stop tightening when damage to the economy from higher borrowing costs becomes more apparent. For the institute's strategists, that point may come before there's a severe enough recession to fully tame inflation, leading them to add inflation-linked debt.
The sticky camp, which appears to include hedge funds with a record short bet on 10-year Treasury futures, generally sees rates higher for longer.
It leans against the market's current stance that the Fed will shift to cutting in the second half of 2023, after at least one more quarter-point increase, likely to be delivered next week. Policymakers, for their part, project that rates will end 2023 at about 5.1 percent—so hiking once more and holding there.
"It felt like 2022 was a year when the bond market was pricing in a Fed pause too soon, and now it feels like 2023 is the year the market is pricing in rate cuts too soon," said Blerina Uruci, chief U.S. economist at T. Rowe Price.
Higher rates don't bode well for corporate profits. With that in mind, Glenmede, which oversees about $41 billion, has been underweight in equities since early last year. "The punch of higher inflation, followed by higher rates, is enough of a negative to the economy that we should see at least a mild recession, and stocks typically don't do well even in mild recessions," said Jason Pride, chief investment officer of private wealth at the firm.
Cooling Camp
The flip side in the debate sees a clear trajectory of cooling prices as the economic pain builds. "The strong conviction we have is that all the monetary tightening of the last year (which is still ongoing) will probably bite soon, bite hard, and will hurt for up to a year," Mike Riddell, who manages the £2.25 billion ($2.8 billion) Allianz Strategic Bond Fund, said via email.
If growth is much weaker than markets expect, "I would absolutely expect inflation to fall below target over the next couple of years," he said. The fund is long core-rate duration given the risk of a severe downturn, he said.
TCW, meanwhile, is positioned for an outcome that aligns with the market's bets on the Fed path. "The bigger picture for us is that even though we don't think inflation is going quickly down to 2 percent, the disinflationary trend is in place," said Steve Kane, co-chief investment officer at the firm, which manages $205 billion. "We like the front end of the yield curve," he said. "When the Fed eases—and that's a key part of it—that front part of the yield curve rips."
It's a result he says may take a few quarters to play out.
Stagflation Risk
There's a third scenario to consider. Anna Wong at Bloomberg Economics sees not just a recession, but "growing stagflationary risks in the rest of the year." That environment could pressure both bonds and equities, with inflation still elevated as growth weakens.
What it boils down to is that inflation is proving as difficult to forecast now as it was while prices soared earlier in the pandemic. In June, for example, economists surveyed by Bloomberg predicted a 5.1 percent annual rate for the final quarter of 2022. It came in at 5.7 percent. Fed policymakers didn't do much better: In June, they saw year-end headline inflation of 5.2 percent, based on their median projections.
"The drivers of inflation are so many and varied: There are both demand and supply factors, short and long-term factors," said Jonathan Gregory, head of UK fixed income at UBS Asset Management. "People have been getting inflation wrong for a very long time."
—With assistance from Kenneth Hughes, Sujata Rao & Sarina Yoo.
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