Wednesday 19 May 2021 by Andrew Mayes Bond-sell-off-takes-a-pause-800 Company research

Bond sell-off takes a pause - Executive Summary

Inflation expectations move into target range as participants debate whether inflation is more than just ‘base effects’ and other transitory factors.


  • Over the next year or so it is almost certain we will see episodes of rising prices as the weak economic data of 2020 is replaced by more ‘normalised’ data in annual measures of inflation. At the same time, certain pressure points stemming from a demand-supply mismatch are emerging as a greater sense of normality resumes. The question is whether these price pressures are simply a reflection of catch-up growth or set to become more entrenched.
  • In time we would expect an increase in the availability of labour and other components in the supply-chain to relieve many of these constraints (and associated inflation)--but it’s unlikely to be a smooth transition, and some inflation may just turn out to be more than just transitory. With central banks targeting actual inflation--not merely expectations or forecasts--and willing to maintain a supportive policy until their objectives are met, the risk to the upside of higher (structural) inflation is likely to remain elevated for much of this year.
  • Key to meeting central bank objectives of full employment and inflation will be to close the output gap and reduce underemployment--a significant impediment to stronger (wage) inflation over the last decade in Australia. To do so would be to overcome the moderation of inflation over the past few decades, influenced by an increase in the supply of capital and reduced demand for capital.

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  • While it is conceivable that the closure of international borders--in-effect reducing the supply of capital--will support progress toward full employment and stronger (wage) inflation, assuming improving vaccination rates pave the way for greater freedom of movement, we believe a reversion to something broadly mirroring the pre-pandemic status quo is more likely.
  • Nevertheless, given the level of fiscal support globally, particularly in the US, we see room for yields to trend higher this year as the economic recovery progresses--although we expect the increase to be slower with the snap-back to pre-pandemic levels and sell-off on concerns over premature tapering largely behind us.
  • The exit path from unprecedented support is likely to be complicated and volatile. With central banks willing to tolerate higher inflation, any sense that stronger inflation carries more than a transitory effect is likely to see markets respond sharply (wider yields). Clearly, the reverse is also true.
  • For bondholders, there is no shortage of variables to consider at present. While the need to consider inflation protection is evident, the upshot is that the steeper yield curve increases the yield on new issues and the relative attractiveness of fixed income strategies that benefit from steepening yield curves.

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