(Bloomberg) -- The danger of a central bank policy mistake has increased, but the bond market isn’t fully reflecting the appropriate inflation risk premium, according to one of the world’s largest bond investors.
Fading monetary and fiscal stimulus next year and efforts by authorities “to engineer a growth handoff to the private sector” create a higher risk “of a policy mistake,” according to the asset allocation outlook published Tuesday by Pacific Investment Management Co. A more volatile macro climate raises the prospect of fatter tail risks, meaning larger positive or negative outcomes for investors.
“In the left tail, inflation is more persistent, forcing central bankers to tighten policy sooner than planned, hampering economic growth in highly indebted economies,” wrote Pimco portfolio managers Erin Browne, who specializes in multi-asset strategies, and Geraldine Sundstrom, who follows the Europe, Middle East and Africa region.
The potential “right tail” outcome is the prospect of higher Treasury yields in 2022, as “a high personal savings rate creates room to support consumption, while the push for physical infrastructure can drive investment and productivity gains, creating a virtuous cycle that would likely be a boon for economic growth,” the strategists wrote.
Duration Diversity
November consumer price data is due at the end of the week and is expected to show U.S. headline inflation running at its fastest pace since the mid-1980’s. Recent indications of a hawkish policy shift by the Federal Reserve to stem elevated inflation pressure has prompted a surge in bond market volatility. A sharp decline in long-dated Treasury yields in recent weeks is seen reflecting concerns that tighter Fed policy will eventually slow the economy and limit the current expansion.
Investors are clearly covering themselves. A Bloomberg index that measures the performance of Treasury Inflation Protected Securities (TIPS) has gained 5.4% this year, while baskets of nominal government bonds are in the red for 2021. Further gains for TIPS beckon, according to Pimco, which is maintaining “a modest overweight position” for them in multi-asset portfolios.
“Although inflation breakevens have moved significantly higher, in our view they still do not fully price in an appropriate inflation risk premium given the potential for a right tail outcome over the months to come,” the strategists wrote.
Pimco expects nominal government bond yields “to trend higher over the cycle as central banks raise rates.” But in spite of that bearish outlook, Browne and Sundstrom argue that high-quality debt can help offset losses for riskier assets held by investors. The price of long-dated government bonds has a higher sensitivity to changes in interest rates, and their elevated duration helps them appreciate markedly when risk sentiment turns against equities.
“In a multi-asset portfolio context, we believe in the role duration can play as a diversifier,” they wrote.
©2021 Bloomberg L.P.
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