BlackRock recommended investors reduce their holdings of government debt and increase their holdings of inflation-linked bonds and investment-grade bonds.
On Monday, BlackRock strategists said traders who had begun betting on a sharp slowdown in inflation would be disappointed.
While BlackRock acknowledged that price pressures were falling faster than expected, the firm questioned the market view that inflation would fall toward the Fed's 2% target. The world's largest asset management company recommends that investors reduce their holdings of government bonds next year and buy inflation-linked bonds (TIPS) and investment grade (IG) bonds.
Scott Thiel, chief fixed income strategist at BlackRock, expects U.S. inflation to fall to just 3.50% by the end of 2023 amid continued labor shortages, rising wages and falling inventories. By comparison, the one-year inflation swap rate is 2.38% and the breakeven rate on the 10-year U.S. Treasury bond is 2.14%.
Thiel said in an interview:
"We just think the inflation target is too low. The fluctuations in CPI data are what the market should expect. It is difficult to predict accurately month by month. But it may be easier to reduce from 7% to 5% than from 5% to 3%."
The bond market expects inflation to fall quickly to the Fed's target level
BlackRock expects the Fed to raise interest rates to 5% in the first half of 2023, with long-term inflation then stabilizing around 3%. Data last week showed that the market's inflation expectations (as measured by the bond break-even rate) fell sharply after the U.S. CPI recorded its smallest monthly increase in more than a year in November.
The Federal Reserve has sharply raised borrowing costs to combat the worst inflation in decades, and the key question for markets is when interest rates will peak.
Thiel believes that long-term structural changes will keep inflation rising. He said that means the Fed currently has no choice "but to be hawkish." Policymakers at the Federal Reserve and the European Central Bank both warned last week that terminal interest rates would be higher than markets expected. Thiel said: "Looking ahead, geopolitical risks, demographics and the transition to net-zero emissions will keep inflation high. Should policy rates fall from 5% to 3% over the next two years? Not in this environment."
BlackRock recommended in its outlook report last month that investors "maximize their holdings" of inflation-protected securities in their long-term strategic portfolios. While global inflation-protected bonds have been among the worst-performing fixed-income securities this year, there are signs that things are improving, with them on track for their first positive quarter in a year.
BlackRock also recommended underweight government bonds. Thiel said government bonds would offer little protection in the current environment. Long-term yields may underestimate the risk of interest rates remaining high for an extended period of time, and the fact that central banks will have to reduce their large bond holdings in times of crisis, thus increasing the supply of debt. Thiel added:
"Policy rates have to go higher."
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