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Global investors bet against central banks' aggressive tactics
GLOBAL BOND investors are betting against the increasingly aggressive tactics taken by central banks in the chase for economic growth, by turning to strategies that profit when inflation fails to pick up.
In the options market, trades that make money if inflation drops below one per cent - and even below 0 per cent - have increased. Money managers are buying into government debt, undeterred by negative yields. They are also holding cash, which offers flexibility in the event of an economic contraction.
These so-called deflation trades may prove even more popular around one of the first major set-piece data releases of the fourth quarter: Friday's US jobs report. That could set an uneasy tone for markets into the latter part of the year, with no shortage of risk factors ahead.
"The first sign of a change in the labour market, we and the market are going to scream recession," said Russell Silberston, a money manager at Investec Asset Management, which is overweight cash. "We are running very light risk because the path is so unclear."
In Europe, a gauge of where markets expect the pace of price rises to be in up to a decade's time, the five-year, five year inflation swap rate slumped to 1.18 per cent. That leaves it just above the record low of 1.13 per cent, seen earlier this year and well short of the European Central Bank's goal of inflation running close-to, but below 2 per cent.
In the US, inflation expectations as measured by 10-year break-evens are heading back down to some of their lowest levels since 2016, retesting a trough last touched earlier this month. A forecast issued on Monday from Fitch Ratings that global growth will hit an eight-year low in 2020 also pointed to a lack of traction for economies around the world. It came after some of the loudest doubts about the ability of monetary policy were voiced by top-level policy makers and politicians.
Mario Draghi, the outgoing president of the European Central Bank, led calls for fiscal stimulus in Europe. Across the Atlantic, sustained criticism of Jerome Powell, chairman of the Federal Reserve, has come from US President Donald Trump. A range of markets that gauge expectations for inflation - which usually needs economic growth in order to last - have tracked the dwindling level of faith in the outlook for the return of rising prices. If correct, the consequences for a range of current valuations for growth-sensitive assets across global markets could prove seismic.
After a mixed run of numbers in Europe, Friday's US jobs data may set a clearer direction. While German joblessness fell unexpectedly on Monday, inflation data there and from Spain missed forecasts. The global nature of deflationary risk is showing up in unusual locations, including South Korea.
Ahead of the Labor Department's set-piece release, economists surveyed by Bloomberg expect to see the creation of 147,000 jobs in the US outside the agricultural sector in September.
The unemployment rate is expected to hold at 3.7 per cent, while year-on-year average hourly earnings growth rate is also forecast to be flat, at 3.2 per cent.
Commerzbank AG identifies a deepening sense of pessimism. "The ongoing pressure on inflation break-evens in both euro and dollar shows signs of switching from lowflation to deflation hedging," said Michael Leister, head of rates strategy at the German bank.
"If you benchmark break-evens against the central bank easing and oil dynamics, it's very sobering." Hopes that the slowdown in the first half of the year was just temporary are rapidly evaporating as economic data slows and global trade tensions show no signs of easing. By most accounts, German manufacturing - a key driver of the region's economy - is already in recession, while there are signs it is spreading to services and the wider region.
Pacific Investment Management Co stops short of pointing to a global economic contraction as its base case, but it, too, is cautious.
"You do have elevated recession risk, you do have the potential for a grab for duration," Andrew Balls, chief investment officer for global fixed income, told Bloomberg TV. "We don't want to have big underweights here."
Citigroup Inc is recommending investors short inflation, via inflation swaps, targeting a drop to one per cent, calling the ECB's efforts to revive expectations "futile".
There's been "more bad data, falling inflation expectations, ECB resignations and unwanted tightening", wrote Citi strategists including Jamie Searle in a note to clients. It's "hardly an auspicious start for an ECB package designed to re-anchor inflation expectations closer to target."
Aviva Global Investors is taking a cautious approach to the US, buying 30-year real yields via inflation-protected Treasuries as a hedge against a global recession. They're still positive, unlike similar-dated ones in Europe, and offer much-sought-after duration.
"It's hard to see that the stimulus so far has been enough to do the job," said Joubeen Hurren, a money manager at Aviva. BLOOMBERG