Peak inflation arrives. Now what? - Market views from BlackRock Systematic Fixed Income
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BOND MARKET INSIGHTS
Peak inflation arrives.
Now what?
Market views from BlackRock Systematic Fixed Income
Peak inflation appears to have arrived. What’s next?
The central bank narrative has shifted from a focus on Jeffrey Rosenberg
the pace of tightening to the terminal rate required to Sr. Portfolio Manager
bring inflation back down to the targeted level. Systematic Fixed Income
Throughout 2022, expectations for peak inflation have been
continually disappointed. Now, signs are emerging that we’ve
reached peak inflation.
Tom Parker
Heading into 2023, the likelihood of bringing inflation down to Chief Investment Officer
the targeted 2% rate depends on whether policy is sufficiently Systematic Fixed Income
restrictive. History suggests that this may take longer than
markets expect. The level of policy rates required to conquer
inflation will have great implications on market returns and the
durability of the 60/40 portfolio.
Key highlights
The arrival of peak Are conditions Post-COVID secular
inflation restrictive yet? forces at play
The long-awaited peak in The policy narrative has shifted The level of the nominal Fed
inflation appears to have to a focus on whether funds rate that is adequately
arrived—belatedly. Upside conditions are restrictive “restrictive” depends both on
inflation surprises throughout enough to eventually bring the inflation outlook and the
2022 have extended the inflation back to the 2% target. outlook for real rates. What do
timeline of the peak and Taming inflation may take structural economic changes
eventual easing of inflation. longer than markets expect. mean for the “neutral” real rate?
BlackRock.com/SFIOutlook
Winter 2023 | Systematic Investing | Market Outlook
CPSM1222U/S-2639381-1/7After peak inflation Figure 2: Services inflation continues to
accelerate and proves difficult to tame
The long-awaited peak in inflation appears to have arrived— Goods versus services inflation
belatedly. Throughout 2022, expectations for inflation have 20%
been serially disappointed. Now, the contour of
expectations remains the same but with a delayed end 15%
point. Figure 1 highlights the evolution of consensus
market inflation expectations. For the majority of the last 18 10%
months, consensus views on inflation expectations have
YoY
5%
reflected a gradual decline to a pre-COVID level of 2-2.5%.
For each successive miss in inflation failing to reach its
0%
peak, expectations for the peak and gradual decline of
prices have simply moved further out in time. -5%
Figure 1: A delayed timeline for the peak and
decline in inflation Goods Inflation Services Inflation
Consensus market inflation expectations
Source: Thomson Reuters, as of 10/15/22. Goods inflation: US CPI – Commodities Less
10% Food & Energy SADJ. Services inflation: US CPI – Services Less Energy Services SADJ.
Consensus
Hundreds
9% forecasts
US Core CPI
8% Good for earnings, bad for inflation
US Headline CPI
7%
Persistent services inflation reflects the pricing power that
6%
companies discovered post-COVID. In this sense, the
5%
resilience we have seen in earnings—good news for stocks—
4% parallels challenges in the narrative for steadily declining
3% inflation—bad news for the inflation outlook. The ability for
2% companies to pass on higher prices reflects the ability of
1% consumers to absorb these costs. This is partly explained by
0% consumers drawing down on pent up savings from the
Jul-19
Jul-20
Jul-21
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Jul-23
Apr-19
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Apr-23
Oct-19
Oct-20
Oct-21
Oct-22
Oct-23
Jan-19
Jan-20
Jan-21
Jan-22
Jan-23
COVID-19 crisis and stimulus. But equally, it reflects the
significant power that workers also discovered following the
pandemic. Figure 3 shows historic labor market tightness
Source: Bloomberg, as of 9/30/22.
through the vacancy to unemployment ratio. Since COVID-
Little has changed in the consensus outlook for the 19, labor scarcity has remained at the root of the dramatic
trajectory of inflation. This view is largely fueled by bottom- increase in wage compensation growth. This underlies the
up forecasting for each component of inflation readings. alternative to the consensus inflation view, with the
The individual component pieces have clear rationale and beginning of a wage-price spiral potentially reflected in
data driving expectations for price declines. The first of stubbornly high services inflation.
which are supply-constrained goods categories that
Figure 3: Labor scarcity reflects the post-
accounted for the initial surge in inflation and “transitory”
narrative. Shelter and Owners’ Equivalent Rent (“OER”), the
COVID pricing power of workers
Job vacancy to unemployment ratio
housing components of the Consumer Price Index (“CPI”),
come next as prominent contributors to eventually easing
2.5%
inflation. These categories impact CPI readings with US Job Vacancy to Unemployed
notable lags to more recent data that show new rental
leases starting to fall. Furthermore, the lagged impact of 2.0%
significant increases in interest rates slowing the housing
market should lead to further future declines in the
1.5%
category. Used cars, airfares, semiconductors—the data and
analysis surrounding each of these components is
encouraging and fuels the consensus outlook. 1.0%
This all comes with one wrinkle. While goods prices appear
to be normalizing and playing to script, services inflation— 0.5%
much harder to forecast through comparable bottom-up
techniques—remains stubbornly high. Figure 2 highlights
0.0%
goods versus services inflation, with services inflation 2000 2003 2006 2009 2012 2015 2018 2021
showing signs of acceleration.
Source: Bloomberg, as of 10/31/22. 2
CPSM1222U/S-2639381-2/7Are conditions sufficiently Powell is referring to the lessons from the inflationary
recessions of the 1970s and early 1980s. One argument
restrictive yet? that supports the Fed’s potential to avoid the same
inflationary outcomes this time around is that they’ve
The potential that we have reached peak inflation brings learned from the experience (and mistakes) of the past. As
about an evolution in the policy narrative for the U.S. Powell and several Fed committee members have reiterated,
Federal Reserve (“Fed”). It is no longer about the pace of the costs of reining in inflation that wasn’t sufficiently
increases in the policy rate, but rather what level of the controlled in the initial attempt far outweigh the costs of
terminal rate will result in conditions that are restrictive having conquered it the first time.
enough to bring inflation back down to the 2% target.
This is because once inflation bleeds into inflation
Remarkably, little in what we have seen from policy expectations (or more accurately inflation behavior), it’s very
tightening to date has had much of an impact on the difficult to re-anchor those expectations at lower levels of
inflation outlook. As previously mentioned, the declines inflation. What would appear to be a simple solution of
from peak inflation reflect mostly the supply-constrained letting 2% long-term inflation expectations increase to 3 or
goods categories and the lagged impact from housing 4% is actually a difficult proposition. Why? It diminishes
(where the effects of tightening have been most significant central bank credibility, which is required in order to keep
in the real economy). But the “long and variable lags” in expectations anchored and at the heart of what we
monetary policy and the idea that policy has only now understand the inflation-setting dynamic to be.
moved from accommodative into restrictive territory
Despite today’s central bankers' benefit of hindsight, the
suggest that we may not see the impact on inflation for
errors of their predecessors are not so easily avoided. The
another 12-18 months. That trajectory appears reflected in
eventual declines in inflation in the recessions of 1970,
consensus expectations, yet it leaves a lot of uncertainty as
1973, and 1980 significantly lagged the policy tightening of
to where the Fed’s terminal rate will end up and whether
the time. The policy tightening itself may have been
that rate will deliver sufficient restriction to tame inflation.
delayed, but once underway, delivered the level of
Will the terminal rate be enough? restriction required to do the job. And that job resulted in
the expected job losses across the economy.
Market expectations for the terminal rate hover around 5%
by May of 2023 (Figure 4). At this point, the market expects The error was not in failing to raise rates, but failing to keep
the Fed to have had success: restrictive policy brings rates high enough for long enough—which is easier said
increased unemployment and engineers a recession. than done. In all three historical episodes, rising
Importantly, the market expects inflation to decline and unemployment put pressure on the Fed to cut policy rates,
quickly be met with lower policy rates without a material lag. to which it succumbed (Figure 5). This was even true during
the first recession with Paul Volcker as Fed Chairman, who
Figure 4: Markets expect policy rates to act is known for later “keeping at it” and eventually restoring
fast
. against inflation price stability in 1982.
U.S. Federal Reserve Implied Policy Rates
Figure 5: Job losses have historically put
5.25% pressure on the Fed to ease conditions
Inflation, policy rates, and unemployment in past inflationary
5.00%
recessions
4.75%
20%
Hundreds
4.50% 18%
4.25% 16%
14%
4.00% 12%
10%
3.75%
8%
3.50% 6%
Sep-22 Mar-23 Oct-23 Apr-24 Nov-24 May-25 Dec-25 4%
11/28 11/3 2%
0%
Source: Bloomberg, as of 11/28/22.
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
But do policymakers agree? Fed Chairman Jerome Powell’s
unwavering commitment to conquering inflation suggests
otherwise, stating that “history cautions strongly against Recession Fed Funds Rate
prematurely loosening policy” and “we will keep at it until Core CPI Unemployment
the job is done”.1
1Source: Bloomberg, as of 8/26/2022. Source: Bloomberg, as of 11/25/22. 3
CPSM1222U/S-2639381-3/7The challenge for the Fed today is to get rates to a level Figure 7: Expected terminal rates and inflation
that’s sufficiently restrictive to slow the economy, absorb imply restrictive real policy rates
the political pushback to signs of “success” (rising Real Policy Rates and Recessions
unemployment and a slowing economy), and keep rates
20% 100%
restrictive for long enough to ensure a durable decline in
Hundreds
18% 90%
inflation. In addition, the decline in inflation needs to
ensure declines in inflation expectations. The market 16% 80%
believes the Fed’s success in the former (causing a 14% 70%
recession) and sufficient progress on bringing down 12% 60%
inflation, will lead to a traditional “Fed pivot,” aimed at 10% 50%
fighting the recession that was just created. 8% 40%
However, the potential for more sticky inflation alongside 6% 30%
rising unemployment may present a more challenging 4% 20%
picture—both for policymakers and markets. Historically, 2% 10%
inflationary recessions have diminished the impact of 0% 0%
short-term rate cuts, and reduced the response in falling
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
interest rates at the more economically impactful long-end
of the yield curve. This lack of long-end rate declines can Recession
undermine the traditional role of duration in portfolios to Long Term Estimate of Nominal Neutral Rate
deliver positive returns during recessionary periods. Fed Funds Effective Rate
Core PCE
Secular forces in a post-
Source: Bloomberg, as of 9/30/2022.
The neutral level of real interest rates may also be
COVID world increasing with the forces at play in a post-COVID world.
The long decline of real neutral rates in the pre-COVID
Considering the impact of post-COVID secular themes, the period reflects dominant structural characteristics of
level at which the Fed is expected to stop raising interest secular stagnation. Broadly, this shows in the excess supply
rates, or the terminal rate, may prove to be insufficient. The of savings over the surfeit of investment demand. But, both
level of the nominal Fed funds rate that is adequately sides of that equation may be shifting.
“restrictive” depends both on the inflation outlook and the
Significant changes in China’s economic model and
outlook for real rates, or inflation-adjusted interest rates. In
relations with western economies are impacting the degree
the consensus view, a 5% terminal rate coupled with 3%
of globalization of trade flows. As companies may shift from
inflation by 2023 implies a 2% real Fed funds rate. Relative
a “just-in-time” to a “just-in-case” supply chain model,
to the post-GFC world where the equilibrium real rate fell
favoring reliability over cost-efficiency, the reduction in
close to zero (Figure 6), this new implied rate would be
global trade may reduce the amount of global savings held
associated with 200 basis points of positive real rates. Such
in dollars, which in the past held down real rates. Significant
a positive level of real rates would be considered restrictive
investments needed to fund the energy transition further
relative to history (Figure 7).
add to increased investment demand. Additionally, the
Figure 6: Historical estimated “real” neutral demographic acceleration of aging populations in
rates advanced economies and China represent a structural
Laubach Williams estimate of real neutral rates transformation in the global labor picture from one of
6%
surplus to one of scarcity.
Hundreds
Whether these factors are putting upward pressure on real
5% interest rates will be seen in how the economy responds. A
higher rate of inflation may be an indication of a higher
4%
neutral real rate. Post-GFC, meagre economic growth rates
followed substantial policy accommodation, suggesting a
3%
lack of interest rate sensitivity of the economy. This factor
may contribute similarly to less economic slowing from the
2%
current policy stance of restrictive policy, and hence a much
1% greater degree of tightening necessary to reduce inflation.
Though the consensus view expects a steady decline in
0%
inflation and a Fed pivot to modest cuts in the second half
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
2018
of 2024, the substantial uncertainty suggests a need to
remain balanced in portfolios to the potential alternative
Source: https://www.newyorkfed.org/research/policy/rstar as of 6/30/20. outcomes.
4
CPSM1222U/S-2639381-4/7Implications for portfolio Figure 9: As the stock/bond correlation turns
positive, cash becomes a better risk reducer
construction of higher cash Portfolio risk under varying stock/bond correlation levels
rates and less bond ballast 11%
Negative stock and bond returns in 2022 reflect the effects 11%
of the Fed’s tightening response to inflation and the
10%
resulting recession risks. An additional casualty is the loss Bonds better risk
of the long-held perception that bonds hedge stocks. 10%
Portfolio Risk
reducers
Clearly, when inflation is the underlying cause of market 9%
losses, bonds lose their hedging efficacy. Figure 8
9%
highlights the rolling three-month correlation of daily stock
and bond returns which has turned significantly positive as 8%
both asset classes lost money this year. Cash better risk
8% reducers
7%
Figure 8: Stock/bond correlation is now
7%
significantly positive
Rolling 3-month correlation of U.S. stocks and bonds 6%
-100% -50% 0% 50% 100%
100% Stock Bond Correlation
80% 60/40 60/30/10 60/20/20
60%
Stock-bond correlation
Source: BlackRock calculations. Portfolio risk reflects a 4% assumption for bond volatility,
a 15% stock volatility and 0% cash volatility.
40%
20% However, as the stock/bond correlation approaches zero
0% and higher, portfolio risk is lowest for the portfolio with the
highest allocation to cash. This is seemingly intuitive, as
-20% cash is always a zero-correlated asset (its price doesn’t
-40% move), and from a risk reduction perspective, the zero
-60% correlation of cash is preferable to any positive correlation
from bonds.
-80%
Note that this perspective only considers portfolio risk, not
-100%
expected portfolio return. So, while cash may be the better
1985
1970
1973
1976
1979
1982
1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
2018
2021
diversifier under a zero or positive stock/bond correlation,
using cash may not be ideal for portfolio construction due
to its impact on returns. Low (or zero) rates on cash can
Source: Bloomberg, Federal Reserve as of November 25, 2022. Notes: The return of bonds drag on expected returns and diminish the appeal of cash
are based on the daily return of 5-year zero-coupon Treasury bonds from 1971 to 2022. as a portfolio holding.
Stocks are represented by the S&P 500 Index from 1971 to 2022. Index performance
shown for illustrative purposes only. You cannot invest into an index. Past performance is However, with significantly positive yields available on cash
no guarantee of future results. today, we need to consider not only stock/bond correlations
for optimal portfolio construction, but additionally the
What are the resulting implications for portfolio expected return differences between bonds and cash. The
construction? We illustrate the considerations of positive next two figures highlight this perspective.
stock/bond correlation using some simple stylized portfolio
construction examples. Consider a hypothetical three-asset
portfolio of stocks, bonds, and cash, and the question of
what the optimal portfolio allocation is when the correlation
between stocks and bonds turns positive.
Figure 9 highlights the interaction between stock/bond
correlation and portfolio risk for three hypothetical
portfolio allocations: a 60/40 stock/bond portfolio, a
60/30/10 stock/bond/cash portfolio, and a 60/20/20
stock/bond/cash portfolio. When the stock/bond
correlation is negative, portfolio risk is lowest for the
portfolio with the highest allocations to bonds.
5
CPSM1222U/S-2639381-5/7Figure 10 highlights the expected return per unit of risk for With lower expected returns of bonds over cash (Figure 11),
our three hypothetical allocations (60/40, 60/30/10, the portfolio Sharpe ratios are nearly equal at zero
60/20/20) assuming a 3% difference in bond returns over stock/bond correlation. When cash returns start to become
cash returns (an estimate of what we may have expected competitive with bond returns, and bonds no longer offer
with zero interest rates). Due to the higher expected returns clear diversification to the portfolio (represented by a
on bonds compared to cash, the 60/40 portfolio dominates significantly negative stock/bond correlation), cash starts
the portfolios with cash allocations for each level of to become a better portfolio allocation relative to bonds. 2
stock/bond correlation.
To state this another way, when cash offers no yield, bonds
are almost always a better portfolio choice. Even with a
Figure 10: When cash offers no yield, the positive stock/bond correlation, bonds offer a higher return
60/40 prevails per unit of risk for the portfolio. But as higher yields on cash
Sharpe ratios by stock/bond correlation with 3% expected narrow the expected return differential, bonds require more
outperformance of bonds over cash of a negative correlation expectation to stocks to maintain
portfolio attractiveness relative to cash.
95%
In the past, the strongly negative correlation that bonds
90% offered stocks during stock downturns reflected the bond
market pricing in the willingness and ability of the Fed to
85%
aggressively cut rates in response to a recession. On
average, that translated to around 500bps of rate declines
Sharpe Ratio
80%
(and a significant ramping up of quantitative easing “QE”
75% and flattening of the yield curve when the zero lower bound
got in the way).
70%
65%
50bps of cuts, not 500bps
Today, inflation undermines the willingness and ability of
60%
the Fed to respond so forcefully to such a recessionary
-100% -50% 0% 50% 100% scenario. And though the market prices in a “pivot” in Fed
Stock Bond Correlation policy to cutting interest rates around 50bps in mid-2023,
60/40 portfolio 60/30/10 60/20/20 that is not the same thing as the market expecting the Fed
to cut rates to the full extent of typical recessionary policy
Source: BlackRock, as of 11/30/2022. stance (over 500bps). To expect that would be to say that
the Fed is going to try to ease policy to stimulate the
Now, consider the impact on portfolio efficiency (e.g., the economy in response to a recession that it created to fight
portfolio Sharpe ratio) when the return advantage for bonds inflation. As a result, a zero correlation may represent a
over cash falls from 3% (as shown in Figure 10) to 1% as more reasonable expectation going forward for stock/bond
shown below in Figure 11. correlation.
Figure 11: When bond vs. cash returns narrow,
diversification grows in importance Implications for investors
Sharpe ratios by stock/bond correlation with 1% expected
The loss of negative stock/bond correlation and the rise
outperformance of bonds over cash
in expected returns of cash has made cash a more
attractive asset for portfolios relative to bonds. Cash is
95%
the most general “zero correlated asset,” but any
90% investment strategy approximating zero stock
correlation can be thought of as an alternative portfolio
85% diversifier to bonds. When considering alternatives with
expected zero equity correlation, the expected alpha
Sharpe Ratio
80% determines the attractiveness relative to cash (and
bonds). Furthermore, defensive alpha strategies
75% delivering both negative correlation to stocks and
positive expected returns over cash represent even more
70% favorable alternative portfolio diversifiers in this
environment of zero to positive stock/bond correlation.
65%
60% 2Note that a 1% bond-cash expected return difference is roughly
-100% -50% 0% 50% 100% what we might consider over the 2023 horizon. For cash, a 12-month
CD offers 4% yield. Treasury bonds yield 3.5% currently, and – based
Stock Bond Correlation on market expectations for a Fed pivot next year - a 25 bps decline in
60/40 portfolio 60/30/10 60/20/20 longer term yields adds around 1.5% in price appreciation for a 5%
total return to bonds. Lower return expectations for bonds push down
Source: BlackRock, as of 11/30/2022. the bond allocation (and vice versa).
6
CPSM1222U/S-2639381-6/7Conclusion
Market focus has shifted from identifying the long-awaited These questions will continue to impact portfolios and the
peak in inflation to determining whether conditions are 60/40 investment framework that investors have
restrictive enough to bring inflation back to the target level. historically relied on. The potential for alternative outcomes
The potential for more sticky inflation and rising to consensus expectations may lead to continued pressure
unemployment alongside the “long and variable lags” of on stocks and bonds and require investors to look for other
monetary tightening present a challenging picture—both for sources of portfolio diversification. While peak inflation may
policymakers and markets. Will the implied terminal rate be behind us, the question remains: now what?
bring down inflation as soon as markets expect? Will
policymakers remain committed to conquering inflation
despite expectations of a Fed pivot?
Want to explore more?
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This material is prepared by BlackRock and is not intended to be relied upon as a forecast, research or investment advice, and is not a
recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December
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This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things,
projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this material is at the sole
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