Beyond Bulls & Bears

Fixed Income

Quick Thoughts: Are Central Banks Too Slow to Tackle Inflation?

Are the reserve banks too slow in tackling inflation? Will inflation level off by itself? Will rising rates cause a recession? Stephen Dover, Head of Franklin Templeton Investment Institute, sat down with Franklin Templeton Fixed Income Chief Investment Officer Sonal Desai and Western Asset Portfolio Manager and Research Analyst John Bellows to discuss the investment landscape considering today’s geopolitical and economic challenges.

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Listen to their podcast.

Here are some of their key points:

  • Sonal remains convinced the Federal Reserve (Fed) is behind the curve in raising interest rates. She warned about three months ago the Fed’s move towards hawkishness is a direct result of the persistence of inflation. Looking at the trends over the past three, six and 12 months, she thinks inflation could end the year between 5% and 7%.
  • John remains convinced the outlook for a moderation of price increases is compelling. John acknowledged inflation has not abated in 2022 as he expected. Based on his interpretation of recent data, the pandemic-related factors that caused rising wages, increased housing prices and supply chain bottlenecks are starting to subside.
  • Sonal believes the fiscal and monetary stimulus provided in 2020 sowed the seeds for rising inflation, and supply shocks ignited the upward trend. While rate rises may help in addressing the supply chain issues, the low starting point will force more aggressive hikes than the market expects, and that will have negative implications for growth.
  • John’s outlook is that economic growth will slow on its own in 2022.The inversion of the US Treasury yield curve is signalling that the Fed’s actions are creating the conditions for lower future growth, and this will, in turn, lower inflation.
  • Sonal’s opinion is that the inversion of the yield curve doesn’t necessarily mean lower growth. It has been distorted at the long end of the curve by the Fed’s asset purchase program. However, one shift in her thinking is that the higher levels of inflation could accelerate the spending of pent-up savings, creating risks to future growth.
  • John points out the opportunities in fixed income markets have increased. The reason? Many potential buyers have been scared off by the extreme volatility. During times of uncertainty, investors tend to prefer safer assets, so he believes there is value in diversifying toward neglected areas.
  • Sonal remains committed to the short end of duration. Credit segments that will likely benefit from rising rates include bank loans and commodity-focused emerging markets. As Europe is currently seeing a higher risk of recession, there is potential for finding value in longer-duration assets.

To read more views on inflation from our Fixed Income teams, read “On My Mind: The Fed Takes the Red Pill” and “Six Common Misconceptions About Inflation.”

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Floating-rate loans and debt securities tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Past performance is not an indicator or a guarantee of future results. Diversification does not guarantee profit nor protect against risk of loss.

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