The Inflation Whisperer:
Some success for central banks, but far from a benign year ahead

The path of future inflation is notoriously hard to predict.

Even the central bankers who can pull the levers of monetary policy themselves find their own predictions are rarely correct. And those who seek to analyse their words, engaging in the Kremlinology of pouring over the nuance of their statements, face an even tougher challenge predicting the future.

 

The difficulty arises from the vast array of economic, demographic and market factors that affect inflation rates and the feed back loops, what George Soros called the ‘reflexivity’, which means that the predictions of inflation themselves can change the actual course of that inflation. This latter point makes it like a form of 3D chess.

The year ahead is one which contains by any standards significant macro uncertainty to complicate the picture. On one level you could say policy makers have done their jobs. Headline inflation is down from double digits to much more modest rates right across the rich world. Core measures of inflation seem stuck at above 3% and wage inflation is taking much longer to get under control. Yet in reality two years ago when there were commentators talking about a return to the 1970s we would have taken this level in a heartbeat. The core policy makers will be very satisfied about how this inflation crisis has played out, even if for the electorates the
experience of inflation feels far less benign and far more politically disruptive.

Our focus at Atlantic House Investments is to stick to the data itself and in particular look at what the derivatives markets are telling us about the path of future inflation. This provides an interesting additional data point to asset allocators who may conventionally focus more on the real world evidence of inflation changes. We explore our approach to this in some detail in our first ‘Inflation Whisperer’ podcast here.

Our approach draws us away from focusing on concepts that occupy conventional economists a great deal; such as finding the elusive R* of equilibrium interest rates. We tend to believe R* arguments are attempts by macro economists to identify the reasons why expected higher bond yields have not materialised.

 

Central banks themselves of course focus on derivatives markets too. They tend to rely on the 5-year, 5-year forward inflation swap rate (5y5y). This metric allows the central bank to assess if near-term trends in inflation are feeding into longer-term inflation expectations and hopefully identify early the start of any inflation spiral. This is crucial for central banks as they aim to anchor inflation expectations around their targets.

Currently the 5y5y rate in the US stands at around 2.5%, suggesting that markets anticipate inflation to settle slightly above the Federal Reserve’s target in the long-run. This could be attributed to factors like the threat of tariffs and high government spending under the new US administration in the presence of a fairly-tight Labour market.

 

In the UK the 5y5y rate is higher at around 3%, reflecting concerns about sticky wage inflation, persistent inflationary pressures stemming from Brexit-related supply chain disruptions, expansionary budgets and low slack in the labour market. This higher rate indicates the Bank of England faces a more significant challenge in taming inflation and bringing it back to its 2% target.

By contrast, the Eurozone 5y5y is just over 2%, closer to alignment with the European Central Banks’ inflation target. Whilst this suggests that markets have confidence in the ECB’s ability to maintain price stability in the medium to long-term,
it likely also reflects a possible scenario of very low economic growth should trade wars materialise.

The mathematicians around us might remark that it is quite neat that these rates are close to the 2, 2.5 and 3% levels and that this feels intuitively sensible in terms of inflation in the years ahead in the various regimes.

Markets are therefore entering 2025 without the existential fears around inflation that were amongst us in the period directly after the Covid-19 pandemic. Yet we can hardly characterise the expectations as entirely benign, coming in slightly above banks’ long-term target rates and with the cloud of radically-different US economic policy on the horizon.

Indeed, we would agree with recent analysis from organisation such as Royal London Asset Management which emphasises the concept of ‘spikeflation’ as a risk for markets in the years ahead. It highlights risks such as demographics and debt levels but also less talks about areas such as chronic under investment in commodity extraction as the world engages in an energy transition. These can be sources of episodic and erratic inflation.

There is therefore plenty on the horizon to suggest that inflation will be a source of significant uncertainty in portfolios in the years ahead. This in our view only exacerbates the profound importance of multi-asset investors focusing on judicious duration management.

Our approach on this has been to construct a systematic signal-based approach to duration management that relieves investors from the impossible challenge of attempting to time these incredibly uncertain macro changes. This works to remove some of the heuristic bias that can lead to mistakes in this area. Our Atlantic House Dynamic Duration fund switches systematically between allocations to rates and inflation derivatives, linked to 10-year index-linked bond market yields and signals around central bank credibility and underlying inflation trends.

You can explore our strategy here. Or hear more from myself and Charlie Parker as we discuss next year’s inflation outlook on our Top of the Swaps Podcast.