Inflation and bonds - are we at the foothills of a higher rate regime?

As we work through this strange post-COIVID cycle and (with considerable hindsight) the associated excesses of monetary and fiscal stimulus we are leaning on the expertise of the specialists in our manager line-up 'team'. A very good example of this is Dr Christian Bayliss of Fortlake Asset Management. He has a PHD in inflation forecasting (and is also a pretty articulate and 'hands-on' portfolio manager) so he has been a good one to have on the roster. We expected this morning's conversation to be on the minutiae US inflation data given a widely anticipated data release on Friday. In the event however there were no real surprises but the conversation turned to another are of interest - credit risk and where it is going to materialise (if ever!)

First of all though on Friday's inflation number one of the most notable observations Christian makes is about the increasing predictability of inflation forecasting. The gap between consensus estimates and actual prints has narrowed significantly, indicating that the market is becoming more adept at anticipating inflationary trends. Well we should have seen this one coming as Powell appeared to tell us what it was going to be 10 days ago! More generally this development can be attributed to the shift in inflation from the tradable side of the economy to the services sector. As supply chain disruptions ease and the focus moves towards slow movers like owners' expected rent and market services inflation, the overall inflation landscape does appear to be becoming more stable and consistent.

However, this stability does not necessarily translate to a benign economic environment. The market may have been overly optimistic in pricing in rate cuts, and the current real rates, while not exceptionally low, are close to a neutral real rate of 1.5-2%. There is also some interesting research doing the rounds suggesting that the modern monetary central banking regime has implicitly suppressed yields and that when you look at actual real borrowing costs the financial environment is actually pretty 'easy'. We have some more work to do to substantiate that but it certainly resonates. One implication is that the yield curve has not been nearly as inverted as traditional metrics would suggest. 'Reading between these lines' this would suggest that last years phantom recession was not nearly as likely as the bond market was apparently suggesting (and it's absence not so anomalous). This also suggests that, looking forward the Federal Reserve may have limited room for maneuvers and could find it difficult to lower rates in the face of a stronger economy and financial conditions that are looser than even the Fed expects.

Credit risk appearing (finally)?

On the other side of the Atlantic, the European economy is facing its own set of challenges. The high-yield and private credit markets have witnessed several defaults in recent months, raising concerns about potential risks in these sectors. This may be nothing but it also may be the canary in the credit coal mine that every one has been looking for. It would make sense that cracks first appear in Europe, particularly in the mezzanine parts of private credit, where we might be seeing the intersection of  huge flows of capital and, potentially, lack of underwriting experience. While not all private credit investments need to be painted with the same brush, we think there is a lot of work to be done to make sure we know where the fault lines might be. We'll be working closely with managers like Fortlake as well as Hunt Economics over the next few months on this.