Daniel Ivascyn, Chief Investment Officer at Pimco, stated that if inflation expectations continue to rise, the Federal Reserve and other major central banks will be compelled to act, especially as surging global bond yields could trigger broader financial market turbulence.
Following U.S. airstrikes in Iran in late February, oil prices have spiked sharply. A key U.S. Treasury market gauge of inflation expectations, the breakeven inflation rate, recently climbed to its highest level in over three years. This movement has triggered a significant sell-off in global bond markets, pushing the yield on the 30-year U.S. Treasury to its highest level since 2007 this week.
"If longer-term inflation expectations become more meaningfully unanchored, then even with some economic softness, you would see policy tightening," Ivascyn said in an interview. "That's the market's pain trade," as interest rates would rise, increasing pressure on both equity and credit markets.
This prospect of policy tightening creates a challenging environment for incoming Fed Chair Kevin Warsh. Warsh is set to take over the Fed this month against a backdrop where President Donald Trump has consistently pushed for lower interest rates.
While the Fed has kept rates unchanged so far this year, disagreements among policymakers over the monetary policy outlook have grown. At their April meeting, Fed officials noted that while short-term inflation outlook faces upside risks, "longer-term inflation expectations remain well anchored."
Nevertheless, a widely watched U.S. Treasury inflation measure has reached levels last seen in March 2023. At that time, the Fed was raising rates to combat the post-pandemic inflation surge and the energy shock from the Russia-Ukraine conflict. The U.S. 10-year breakeven inflation rate has now broken above 2.5%, up from around 2.2% at the start of the year. Meanwhile, a closely followed forward U.S. breakeven inflation measure has also risen in recent weeks, though it remains within its recent range.
In contrast, corporate credit and equities have remained resilient despite traders raising expectations for Fed rate hikes, supported by robust U.S. economic data. Swap contracts now almost fully price in a 25-basis-point rate hike before year-end.
Ivascyn noted that the performance of risk assets has been "a bit surprising."
"Buying the dip in equities and credit has been very profitable for about the last 15 years," he said. Treasury yields "could go higher, but we think it’s difficult to have materially higher yields without significantly impacting risk asset markets."
Traders' rapid shift towards betting on rate hikes has enhanced the appeal of junk bonds, which typically have shorter durations and are therefore less sensitive to rising yields. However, with junk bond spreads not far from their 2007 lows, early signs of stagflation risk, and rising defaults in private credit, some investors are beginning to question the exuberance that has recently allowed even some of the riskiest borrowers to access the market.
Policy tightening "could provide some stability to long-term rates, as the market would receive a signal that central banks want to regain control over inflation expectations," Ivascyn said. He still believes that the amount of tightening currently priced into most yield curves is "probably excessive."
Pimco is maintaining a disciplined approach to interest rate risk management, reflecting the uncertainty stemming from "a geopolitical situation where both sides need to reach some sort of agreement."
The bond manager, which oversees $2.3 trillion in assets, typically focuses on longer-term investment horizons. "On a three-year view, we remain fairly comfortable with our rate exposure," Ivascyn said. He added that investors can use the recent jump in U.S. Treasury and corporate credit yields to "build a high-quality fixed income portfolio that can generate a 6% to 7% yield."
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