Analysis

Bond ETFs: Are inflation concerns overdone?

Inflation risk driving outflows from fixed income ETFs

Tom Eckett

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A mass exodus from fixed income ETFs has taken place over the past month with investors increasingly concerned about a spike in inflation, however, there may be reasons to suggest these worries are overdone.

According to data from ETFLogic, the iShares $ High Yield Corp Bond UCITS ETF (IHYU) has seen $470m outflows over the past week, the most across all European-listed ETFs, while the Amundi US Treasury 7-10 Year UCITS ETF (US7) was just behind with $449m outflows.

The picture can be further highlighted in the US with the world’s largest investment grade bond ETF, the $46bn iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), seeing $7.4bn outflows over the past six weeks, the worst run on record, according to data from Bloomberg.

This has been accentuated by short interest – as a percentage of shares outstanding – in LQD which has risen to 18.7%, up from 5.9% since the start of the year, according to IHS Markit.

Driving these outflows areinflation pressures to the upsidewhich run the risk of wiping out bond investor returns.

The logic goes that President Joe Biden’s $1.9trn stimulus package to support the US economy combined with the Federal Reserve’s aim to maintain an accommodative monetary policy will pushinflation expectations higher.

Signs of this have already started to take place with the 10-year break-even rate jumping to 2.2% at the start of last month, its highest level since 2014.

As James Knightley, chief international economist at ING, said: “Inflation is undoubtedly going to move higher in the months ahead. The key questions are how high and how long will it last?”

There are a number of factors at play to suggest inflation concerns, as highlighted by the outflows from bond ETFs, are overdone.

Mark Haefele, CIO at UBS Global Wealth Management, stressed that Biden’s relief is different to stimulus as much will be used to maintain current income rather than increase it adding there is enough slack in the US economy to suggest GDP growth will only pick up towards the end of the year.

“We think that these concerns are likely to prove overdone, but a near-term rise in inflation could still prompt volatility in fixed income and equity markets,” Haefele continued.

“In this environment, in which the medium-term outlook remains favourable but volatility is likely to remain high, investors will need to hold their nerve while looking for opportunities to use higher volatility to their advantage.”

Meanwhile, the International Monetary Fund's chief economist Gita Gopinath forecasts inflation to hit 2.25% in 2022, a level "which is nothing to be concerned about".

"The evidence from the last four decades makes it unlikely, even with the proposed fiscal package, that the US will experience a surge in price pressures that persistently pushes inflation well above the Fed’s 2% target," she added.

This evidence suggests investors may have been too quick to begin the mass rotation out of bonds and into cyclical equities, however, as the old proverbial phrase goes, only time will tell.

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