(Bloomberg) — As surging inflation expectations and Russia’s invasion of Ukraine unnerve bond investors, Robert Mead is mapping out an investment landscape where benchmark interest rates in developed nations rise to around 2% to tame prices.
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The 19-year Pacific Investment Management Co. veteran said that “the destination of rates is not that scary,” even as inflation pressures are compounded by rising energy and food prices as a result of Vladimir Putin’s war. Mead is preparing for a world where central bank rates rise fast and hard enough to tame price growth with 2% as the “new neutral” for “most developed economies that are all highly levered.”
The debate on how far and how fast central banks will hike rates has dominated trading floors as the Federal Reserve battles the hottest inflation since the 1980s. U.S. Treasuries suffered their worst start to a year in four decades, Australian bond yields soared and even tightly-controlled Japanese debt faced selling pressure as funds ditched inflation-sensitive assets.
The invasion stalled the rout in bond markets as investors sought the haven of government debt. But that may be a temporary reprieve before investors return to fretting about inflation. Yields on 10-year Treasuries rose to as high as 2.06% in February, and were at 1.94% on Thursday.
Fed Chair Jerome Powell last week told the Senate Banking Committee the U.S. central bank is on track to begin a series of hikes starting this month to curb inflation, but should move “carefully” because of the war. The U.S. benchmark rate, currently around 0%, averaged 2% in 2018 and 2019 before the Fed cut aggressively to cushion the economic blow of the pandemic.
“Geopolitical events will not let central banks off the hook when it comes to normalization of policy,” said Mead, Pimco’s co-head of Asia-Pacific portfolio management in Sydney. If borrowing costs climb to around 2%, monetary policy “will work in terms of slowing that inflationary impulse,” he said.
Value Down Under
Mead agrees with the markets that rate hikes are needed sooner rather than later to seriously tackle price gains.
In Australia, investors are pricing in an initial increase in June, followed by four quarter-point hikes in the second half, even as central bank Governor Philip Lowe maintains a dovish stance compared to his peers. In the U.S., swaps traders expect the Fed to increase rates six times this year.
Mead expects the Reserve Bank of Australia to start raising rates in June and is looking to buy government debt from Australia to the U.S. to trim an underweight position in bonds.
“Given that we still have in many jurisdictions pandemic policy settings and we also have inflation forecasts that meet the criteria for normalization, risk mitigation for central bankers is to follow a gradual path to normalization,” he said. The danger is that central banks fail to raise rates quickly enough. “That option may end up being an expensive one.”
Read More: Stagflation Threat Rattles Bond Traders as Fog of War Descends
Mead says that, while he expects central bank rates to rise, most of the expected increase is already priced into markets. Australia’s 10-year yields rose to a two-year high of 2.37% on Thursday as investors bet on rate hikes.
“There’s value returning to the Australian bond market because the forward curve has priced in expectations that go all the way from pandemic setting policy to what we would call broadly neutral policy,” he said.
Mead is also looking for assets that will thrive in a world of higher rates, including high-quality financial company paper and assets with less liquidity, such as private equity.
“The two risk premiums that are currently attractive to Australian investors are the term premium — so interest rates curves have sold off a lot — and the illiquidity premium, which never really got expensive. So when investors are looking to build balanced portfolios, having some private assets whether it’s private equity or private debt, we still like those two alternatives.”
As the world gauges the economic fallout of the fighting in Ukraine, Mead sees U.S. Treasuries remaining the top beneficiary of haven flows.
“In a true risk-off, U.S. Treasuries will still be the place for investors to look for safe haven,” he said.
(Updates to add Treasury yields in fourth paragraph, updates Australian yields in 11th)
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