Now that the multi-year bull-run in government bonds appears to have come to an end – are yields about to rise? Global yields, led by US front-end rates, have been on a modest upward trend since late 2016. How much further they increase as we move through 2019 could depend on the inflation outlook, which in turn will likely take its cue from the outlook for wage growth. Here, though, momentous forces are at play. Over the past two decades, the twin tides of globalisation and technological innovation have worked to undermine the bargaining power of labour. The result?
A breakdown in the established relationship between unemployment levels and wages as defined by the Philips Curve and, as a consequence, ever greater uncertainty about the future direction of inflation. For investors this could present a problem. If wage growth does remain subdued, upward pressure on bond yields is likely to be modest. If, on the other hand, wages and inflation expectations do rise, bond yields could be at risk of a spike.
Where, then, should investors turn? Given this background, we think investors could benefit from hedging inflation in an efficient way. The charts above highlight the potential mispricing between 30-year breakeven rates and real yields on 30-year US Treasury inflation-protected securities. Here, if inflation becomes a concern, US breakevens will likely need to rise. If it doesn’t, real yields will need to fall. Therefore, whether or not an inflation genie is unleashed, we think a combination of long positions in US TIPS and US breakeven inflation strategies looks attractive.
Peter Bentley, head of UK and global credit. Insight Investment, a BNY Mellon company