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Fixed Income Quarterly Outlook – Q2 2021

Global Fixed Income

BNP Paribas Asset Management

Key Points

  • The key drivers of economies and markets remain:
    1. Developments in public health related restrictions and vaccine rollouts
    2. Divergence in the fiscal policy response
    3. Differences in the monetary policy response and framework
  • We are increasingly constructive on the inflation outlook
  • The odds of a significant and persistent inflation overshoot have clearly risen
  • The main question is whether, with a fiscal impulse of the magnitude we have seen, the economy is at risk of overheating

The whites of their eyes

The US Federal Reserve’s new average inflation targeting framework means that the central bank will not raise policy rates until realised inflation has risen sustainably to above its 2% target. That is, it does not intend to pull the rate trigger until it sees the ‘whites’ of inflation’s eyes. This is in stark contrast to the measures it took after President Donald Trump’s tax cuts. Then, the (mistaken) expectation that fiscal loosening would boost inflation too much led the Fed to raise the fed funds rate by 200bp over two years.

Investors, however, have greeted with scepticism the Fed’s recent protestations that it will be patient on raising rates. The central bank itself has indicated it will not increase rates until 2024. It will do so only once it has tapered its asset purchases, and the Fed will only even begin that process once it sees that inflation and the labour market have recovered. Bond markets, however, have priced in two rate increases over the next two years. The resolution of this divergence will be the key driver of markets at least through the rest of this year.

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