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Market Extra: Investors see risk of ‘significant overshoot’ of Fed’s inflation target for first time in years, says BofA

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Investors are pricing in risks of a “significant overshoot” of the Federal Reserve’s 2% inflation target for the first time in several years, according to economists at Bank of America Corp.

That is based on an assessment of the so-called breakeven inflation rate — or the difference between nominal and real Treasury yields — which has been rising steadily since collapsing at the start of the pandemic, the economists said in BofA Global Research report Wednesday. “Ten-year breakeven inflation is now at its highest level since before the 2013 taper tantrum, having held up through last month’s bond market rally,” the economists said in their note. 

Investors are paying close attention to inflation on concern that too much could prompt the Fed to raise interest rates or begin tapering its asset purchases sooner than expected, potentially hurting their portfolios. While trying to discern whether any spike in inflation will be merely transitory in the economic recovery, some investors are weighing shifts to their holdings to prepare for the risk that it will be persistent.

BofA Global Research broke down breakeven inflation into an inflation “risk premium” and a risk-adjusted measure of “true” inflation expectations. The “risk premium” piece has surged above pre-pandemic levels, the economists said, reflecting the “unprecedented nature” of the pandemic as well as fiscal and monetary policymakers “attempting to heat up the economy at record pace.”

Asset managers will probably shift allocations due to an increased probability of more persistent inflation, regardless of how temporary inflation may be, according to JPMorgan Chase & Co. strategists Marko Kolanovic and Bram Kaplan.

“Portfolio managers likely will not take chances and will reposition portfolios,” they said in a global markets strategy note. Investors preparing for the risk of persistent inflation should “shorten duration and reallocate from bonds to commodities and equities,” the analysts suggested. “Within equities, investors should buy value and short low volatility style.”

At KKR & Co., Henry McVey, head of global macro and asset allocation, in a report Wednesday said he and his team expect that “a higher risk appetite” in markets will be supported by “strong housing, pent-up demand, historically high savings, and a Fed that is committed to overshooting its two percent inflation target”.

“We are upgrading both our earnings forecast and our year-end target for the S&P 500,” McVey said. “We are lifting our 2021 fair value forecast to 4,320 from 4,050, based on S&P 500 earnings per share of $185, compared to $174 previously and a current consensus of $181.”

The S&P 500
SPX,
+0.07%

closed 0.1% higher Wednesday afternoon, near 4,168.

Read: Hedge funds had become ‘extreme’ sellers of stocks even before Yellen’s interest-rate remarks. Here’s why.

On the bond side, McVey lifted his forecast for the U.S. 10-year interest rate this year to 1.75%, from 1.5%. The yield on the 10-year Treasury note was trading near 1.59% Wednesday afternoon.

However, “The sizeable spike in inflation that we are seeing is likely to prove transitory,” said “Treasury markets historically have overestimated the persistence of early-cycle inflation, as 10-year yields and break-even inflation actually surged the most in the early parts of the last two recoveries.”

Bank of America’s economists described a pickup in inflation expectations as “good news” for the Fed under its Flexible Average Inflation Targeting regime. The central bank has long aimed for 2% inflation.

Many investment managers today have “never experienced a rise in yields, commodities, value stocks, or inflation in any meaningful way,” with only deflationary trades (long duration) working for more than a decade, the JPMorgan strategists said in their note.

“Given the still high unemployment, and a decade of inflation undershoot, central banks will likely tolerate higher inflation and see it as temporary,” they said. The strategists added that “their highest conviction is for rotation towards reflation, inflation, rising yields and reopening themes.”

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