Investors shore up defences against rapid rises in US inflation

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Investors are taking further measures to protect against US inflation running hotter than expected in coming years, marking the latest sign that concerns over price growth persist even as a bond sell-off has eased.

A measure calculated by the Minneapolis Federal Reserve based on options trades suggests a one-in-three chance that the US consumer inflation rate climbs above 3 per cent over the next five years.

The rise in the implied odds to the highest level in eight years shows how traders are seeking to protect themselves against a sustained uptick in inflation even if many Wall Street economists still only expect a gradual rise in prices on the horizon as economic growth accelerates.

Data released last week showing investors have bought up $14.4bn of inflation-protected Treasuries in 2021 have added further evidence to suggest money managers are keen to protect their portfolios.

“It’s not that the market has become inflationist. It’s that the market is uncertain,” said David Riley, chief investment strategist at ‎BlueBay Asset Management. 

Fears of inflation have shaken the $21tn market for US government debt, which sets the baseline for global borrowing costs, since more rapid price growth eats away at the fixed income streams the bonds provide. Long-dated Treasuries suffered the heaviest sell-off in four decades during the first quarter of this year as Joe Biden’s $1.9tn stimulus programme and an improving vaccine rollout brightened the economic outlook.

However, the sell-off has lost steam in recent weeks, with the benchmark 10-year Treasury note yield falling to around 1.55 per cent from a high of nearly 1.8 per cent in late March. Yields fall when prices rise.

Riley said the Minneapolis Fed data showed traders are concerned about higher inflation but not sure if it will materialise. “If the market was really pricing inflation being sustained above the Fed target through next year and beyond, I think [yields] would be meaningfully higher,” he said.

Still, Arend Kapteyn, chief economist at investment bank UBS, said investors were in a “shoot first and ask questions later” mentality when it comes to hedging against inflation.

Fed officials view the inflation risks as “broadly balanced”, according to minutes of its March meeting, with policymakers pointing to forces that could push price growth in either direction.

The central bank targets inflation of around 2 per cent, although it has said that it is willing to allow an overshoot in order to make up for past shortfalls. Consumer prices increased at a year on year rate of 2.6 per cent in March, but economists said this rapid increase was fuelled by a large rebound in energy prices. The ‘core’ measure, which excludes both food and energy, rose a more modest 1.6 per cent.

Runaway price growth and a disorderly rise in bond yields have topped the list of investor worries since March, ahead of Covid-19, according to Bank of America’s fund managers survey.