Navigation in the era of uncertain inflation
Besides lion tamer and the AI alignment scientist, central banker will be one of the most challenging jobs in 2024
Mark Greenwood, Deputy CIO & Head of Investment Risk
Policymakers face substantial challenges anticipating future inflation rates. However, our analysis suggests that sound judgments about allocations to fixed income and inflation assets can be made within the Atlantic House Dynamic Duration fund if careful principles are followed.
The rear view mirror
Monetary policy has been described as “driving while looking through the rear view mirror”. The navigation data available to a central bank relates to the state of the economy weeks or even months ago. Nowcasts can help to track the current state of the economy, but central banks still face unpredictable and lagged effects of their changes to rates.
The rear view mirror shows inflation has been steadily declining in the US and UK. The chart shows the profile of headline inflation in the US and UK, where the dotted line indicates the latest headline inflation figures. To the right of this we show the implied future inflation based on the zero coupon inflation swaps market.
This allows policymakers to view how the market sees the future unfold:
Source: Bloomberg, Atlantic House Investments
The Dynamic Duration Fund's Inflation Momentum signal increases fixed income exposure in a steadily declining inflation environment. At present, it has no allocation to inflation in both the US and UK, but at some point the rate of decline in inflation will level out. Then fixed income exposure will be dialled back and inflation swap exposure increased. This will likely happen within a few months for the US allocation, but will likely take until mid-summer for the UK to reach the same signal.
It is of some comfort to central banks that the markets expect inflation to continue to decline, but other forward looking indicators - such as surveys of inflation expectations - are also useful. These surveys in the US and UK show inflation is under control, yet considerable uncertainty remains.
At Atlantic House we are always weighing risks of different outcomes. Central bankers are no different. One way to gauge uncertainty is to look at the volatility of the market data. The chart shows uncertainty is receding, although in the UK it is still elevated compared with the period prior to 2021.
Source: Bloomberg, Atlantic House Investments. Volatility calculation uses a 180-day moving average of 1y forward inflation, using RPI swaps for UK.
Our Dynamic Duration Market Inflation Credibility signal notes that a high real yield on inflation bonds is consistent with lower expectations of future inflation in the markets. The real yield is the interest rate paid over an above future inflation, so a high real yield acts as a brake on the economy through a higher effective cost of financing investments. Currently, this signal is consistent with full fixed income investment in the US, but for the UK investment is evenly split between fixed income and inflation. To us this seems consistent with sentiment in those markets.
This uncertainty can be seen in monetary policy deliberations. The last two UK rates decisions were almost evenly split and the dispersion in the inflation projection (or “dots”) of Fed committee members is wider than it has been since 2015. Such equivocation is not a normal state of affairs - committees know that strong consensus conveys a more powerful message to markets.
Research by the Federal Bank of San Francisco shows that “disagreement about the inflation outlook is a key component of disagreement about policy” and this disagreement remains high in their chart of Measures of disagreement for the outlook (PCE inflation):
Source: Federal Bank of San Francisco
The sources of volatility in headline inflation may be transient. Core inflation is the basis for the central bank inflation target, but core inflation expectations are not readily extracted from the inflation bond and swaps market where headline inflation is used to index cashflows.
Policymakers track core inflation measures that strip out energy, food and other especially volatile components. Recently we have seen a higher emphasis on “super core” (excluding housing) and trimmed mean measures that look through the noise.
The fund's Policy Credibility signal increases exposure to fixed income once core inflation is within 1% of the central bank target, being 2% in both the US and UK. With US and UK core inflation still running hot at 4% and 5.7% respectively, this signals full exposure to inflation swaps until around summer in the US and early 2025 in the UK.
To summarise then, the sum of the Dynamic Duration's signals for the US imply 67% of maximum exposure to fixed income and 33% to inflation. For the UK, which is at least 6 months behind the US cycle, the signals imply 50% fixed income and 50% inflation maximum exposure.
Fiscal fuel tank
Fiscal and monetary policy work best in tandem. In recent years fiscal policy has been used to rev the engine when growth faltered, but this cannot be sustained indefinitely. With the US and UK are running budget deficits of 7% and 2.3% respectively, the fuel tank is on reserve and there is limited room for stimulus to manoeuvre out of a tight spot. This makes the fabled soft landing scenario all the more challenging for central banks.