Breaking Bonds

Key points

1. Inflation raises central bank uncertainty

Inflation looks like it will “stick” around into 2022—leaving the near-term outlook for central bank policy highly uncertain and inflation-adjusted yields on fixed income firmly negative.

2. When the liquidity spigot shuts off

Markets are witnessing an unwinding in the historic amounts of liquidity pumped into the financial system—adding risk to the prolonged period of reach-for-yield behavior.

3. A sea change in China’s policy reaction

China may be shifting its “lather, rinse, repeat” pattern of policy accommodation—creating a potential drag on global growth.

For the past two years, a set of shared assumptions between market participants and policy makers helped create a somewhat benign investment environment. Inflation would be “transitory,” allowing for a prolonged period of accommodative low rates and stable rate expectations. Ample monetary liquidity would be supplied providing a tailwind for markets to continue to climb. China would answer any domestic slowdown with stimulus, helping to keep global growth on track.

Now, these key assumptions and relationships are in question. The final destination of transitory inflation remains in flux, casting central bank policy into tightening mode in some geographies and uncertainty in the U.S. and Europe. Unprecedented amounts of liquidity are starting to slowly drain from the financial system, creating risks for market participants that have been reaching for yield. China’s reluctance to inject stimulus into its flagging economy may create waves in global growth projections.

Heading into 2022, core fixed income is already on track to post negative yearly returns for only the fourth time since 1976.1 The weakening of these key relationships is creating new challenges for an already challenged asset class.

Inflation raises central bank uncertainty

The market’s trust in a patient pace of rate normalization by central banks has been upended by increasing evidence of “sticky” inflation. A surge in front-end rate expectations reflects that many are reevaluating the thesis that inflation pressures are “transitory” (Figure 1).

Figure 1: Breaking bonds
1-year forward rate expectations

Source text: Source: Bloomberg, as of 10/31/21.