Bond markets and the new inflation reality

By Peter Botoucharov, Emerging Market Credit Analyst with contributions from the developed and emerging market sovereign analyst team.

The persistent nature of the energy shock means inflation is set to rise, which will likely require a more powerful response from central banks than initially expected. Are bond markets fully pricing this new reality? Our sovereign analyst team has undertaken a deep-dive assessment of the landscape, identifying where markets may have priced in too many hikes—creating potential opportunities—and where risks may still be underappreciated.

Moving to stage three of the oil price shock  

We believe the oil shock has moved beyond stage one (initial panic) and two (expectations of a short-lived conflict) and is now transitioning into stage three.

Key stages of oil price shock: 

• Stage 1: initial panic: Investors largely exited crowded trades or reduced positions significantly following the initial shock (early March).
• Stage 2: expectations of short-lived conflict: With limited significant second-round inflationary effects expected, only a moderate impact on monetary policy was anticipated and priced into markets (mid-March to now).
• Stage 3: prolonged disruption: A lack of resolution means sustained energy shortages and the likelihood of second-round inflationary effects starting to become more pronounced. Under these conditions, central banks may be forced to respond more meaningfully (transition underway).

Inflation forecasts on the rise

The ongoing conflict is leading to consumer price inflation forecasts, including core inflation, being revised higher. However, monetary policy pricing has not fully adjusted to reflect these revised consumer price index (CPI) projections, suggesting markets may still view the shock as being transitory. That said, recent moves in the front-end of yield curves indicate that market pricing is moving toward becoming more aligned with inflation expectations. 

Another angle to look at the energy shock is through the lens of recession probability. While recession risks have been rising, we believe they are still being underestimated in the UK, Canada, and the eurozone, and overestimated in Japan. This factor could become increasingly important for rates and yield curve shapes the deeper we move into stage three. 

Implications for positioning in bond markets

Combining this all together, we have turned more cautious on duration, with a broadly negative bias toward developed markets. In emerging markets, we are seeing more nuanced relative value opportunities.

Countries supported by either idiosyncratic fundamentals and/or where markets may have priced in too many interest rate hikes look relatively more attractive in the current environment. Within emerging markets, Hungary stands out in this regard, supported by a new reform-minded government. In Romania, meanwhile, a large base effect could see headline CPI fall from high single digits to the 4% to 5% area by year-end.

Conversely, we are more cautious on markets where relatively limited tightening is priced in. In emerging markets, Peru stands out, as we believe inflationary risks remain tilted to the upside. If these risks materialize, they could put pressure on the central bank to raise rates later this year. Thailand is another example, given it entered this energy shock with interest rates at a cyclical low of 1%, while markets have so far priced only a moderate rise in core inflation. 

Spotlight on emerging markets

Emerging markets broadly entered the crisis with positive real interest rate buffers and better fiscal positions. As a result, many central banks have been willing to adopt a wait-and-see approach to the energy crisis pending more information on its duration and magnitude.   

As the crisis drags on, however, authorities that initially relied on fiscal subsidies to cushion the impact of the shock are having to reevaluate how long such measures can remain in place. These subsidies have taken several forms, including:

1. Tax and excise cuts on fuel
2. Direct subsidization
3. Use of state-owned energy company balance sheets
4. Regulation of end prices which puts pressure on private refiner margins.  

Net energy exporters or broadly energy-neutral countries (Brazil, Colombia, Mexico, and Malaysia) continue to have scope to recycle windfall revenues into subsidies, while net energy importers (India, South Africa) are facing growing pressure to allow prices to adjust.  

Overall, it will be important to distinguish between markets where there is more potential for inflation to surprise to the upside and where relatively limited interest rate hikes are priced, such as Peru and Thailand, and markets that appear to have priced in too many interest rate hikes, such as Poland and Mexico.  An additional consideration is the upcycle building mainly across manufacturing Asia, which could complicate central bank reaction functions.