Inflation data to indicate the most likely yield curve scenario

Pension funds and insurance companies will continue to grow demand for long-dated high quality fixed income assets, while inflation, meaning uncertainty over what happens to interest rates, remains a key focus for investors, according to AXA Investment Managers.

However, this demand might limit how much further bond yields could go, AXA’s chief investments officer, Chris Iggo, said.

According to him, yield curves stabilised, but it was not clear that renewed inflation concerns automatically meant steeper curves, especially in the US where a lot was already done.

Iggo said that the next phase could be curve flattening, especially if markets more aggressively priced in early monetary tightening, and the next few months of inflation data would tell us which is the most likely yield curve scenario for the next two years.

“We can make the argument that when the Fed and other central banks do start to move back to a neutral interest rate, that could be a move of the magnitude of 1% to 2%. Ahead of that happening, cyclicality will dominate, credit will continue to outperform rates and equities should benefit from the strong momentum in earnings growth,” he noted.

“But looking forward, we will hit mid-cycle and monetary policy will be tightened. That will change market dynamics.”

Although there was a broad concern in markets that long-term yields would rise again, threatening fixed income returns, credit spreads and earnings expectations, the AXA IM research proved that a leg steeper in the slope of the US yield curve meant that value and quality continue to outperform growth and momentum. 

“Those fighting the inflation corner will point to these higher monthly inflation rates to argue that we have entered a new regime of inflation dynamics, with expectations rising in the household sector, company’s referencing higher input prices in earnings reports and in communications with investors,” Iggo added.

“In the other camp the argument will be that much of this is frictional, related to temporary supply and demand imbalances and that existing output gaps and entrenched behaviour will limit the longer-term inflation.”