Is Reflation a Risk? — Evening Brief – 11.12.24

Merely eight weeks prior, the bond market appeared poised to achieve a second consecutive year of recovery following a challenging period marked by successive losses in 2021 and 2022. Since that time, the market has faced a difficult environment. Despite a slight year-to-date gain persisting for now, the challenges for fixed-income assets may be intensifying as the market contends with a shifting inflation outlook.

Currently, most of the key bond market sectors are seeing increases for 2024. The iShares iBoxx $ Investment Grade Corporate Bond ETF, for example, is up 15.6% for the year, and high-yield instruments, as measured by the iShares iBoxx $ High Yield Corporate Bond ETF, is up 15.3%. However, the Vanguard Total Bond Market Index Fund (BND) is up a modest 2.4%, or roughly half the year-to-date gain as of the middle of September.

The origin of the bond market’s increased unease is the risk that inflation will reignite. The macroeconomic picture influencing the forecast comprises favorable economic outcomes and apprehensions that president-elect Donald Trump’s win will exacerbate inflation.

Although last week’s U.S. consumer sentiment reading for November considered inflation expectations before the election results, it is worth noting that while one-year-ahead expectations dipped to 2.6% versus 2.7% expected and 2.7% in October, five-year implied inflation expectations inched higher to 3.1% versus expectations of 3.0%, and 3.0% in October.

The drivers for this shift in mindset focus on the ambiguity over the timing and method of Trump’s implementation of his campaign commitments — tariffs, tax reductions, and the intention to deport millions of immigrant workers. These proposed policy changes will likely increase pressure on prices. The extent and duration are contingent upon the depth and breadth of a Trump administration’s commitment to its policy platform.

Determining future developments is challenging due to the ongoing evolution of potential significant changes in US economic policy beginning in 2025 and perhaps beyond.

Consequently, the bond market is requiring an elevated risk premium. The US 10-year Treasury yield has increased by almost 80 basis points over the last eight weeks, reaching an intraday peak of 4.38% last Wednesday. This remains a moderate level compared to this year’s range; yet investors are evidently apprehensive about potential developments for 2025, suggesting that the increase in yields may not have reached its peak.

The October CPI report, published on Wednesday, is critical given increasing inflation forecasts and interest rates. Analysts anticipate a 0.2% month-over-month increase in headline CPI and a 2.6% annual growth. Meanwhile, the CPI swaps market is suggesting a hotter print of 0.3% month-over-month. The Core CPI is anticipated to remain stable at an annual rate of 3.3%. While the Fed may think inflation is heading back to 2%, the market isn’t so sure.

“We don’t just look for a very short-lived overshoot on inflation [due to Trump’s policies], this could be more structural and protracted,” said Mark Dowding, CIO at RBC BlueBay Asset Management.