By Kate Duguid
NEW YORK, March 30 (Reuters) - Bond giant PIMCO's quarterly outlook https://global.pimco.com/en-gbl/insights/economic-and-market-commentary/cyclical-outlook/dealing-with-an-inflation-head-fake published on Tuesday warned that market volatility could rise this year, not because of inflation risks, but because of investors' fears of inflation risks.
Inflation expectations have increased this year as the U.S. economy has begun to recover from the coronavirus pandemic and as investors have bet that the flood of new Treasury debt will erode the value of the dollar. The Treasury Department ramped up issuance last year to $3.6 trillion to fund the U.S. government's pandemic recovery efforts. ING expects roughly $4 trillion to be issued this year, not counting inflation spending President Joe Biden is scheduled to announce on Wednesday.
But California-based Pacific Investment Management Company (PIMCO) argues that although inflation will rise modestly this year, challenges reaching full employment in the labor market will keep inflation in check. The market's current expectations of inflation - reflected in breakeven inflation rates and the prices of Treasury Inflation Protected Securities - therefore look overblown, and could ultimately lead to higher volatility.
"It is quite likely in our forecasts that the coming near-term rise in inflation won't be sustained," wrote PIMCO's global economic advisor Joachim Fels and its chief investment officer for global fixed income, Andrew Balls.
"But it also seems quite likely that financial markets will continue to remain focused on upside inflation risks in the near term and that volatility will continue to be elevated."
PIMCO expects core inflation to remain below central banks' targets in all major economies this year and next. The Federal Reserve's target is 2%.
The potential for this "inflation head fake," means PIMCO currently favors bets on a steepening yield curve. Even if expectations of rising inflation are misguided, those bets, along with an improving economic outlook mean that longer-dated yields are likely to rise.
PIMCO now estimates that the U.S. economy will grow by more than 7% in 2021, the fastest pace since 1984, and that world GDP will rise 6%, up from their January estimate of 5%. With Fed interest-rate policy anchored near zero, a rise at the long end would steepen the curve.
PIMCO sees steeper government yield curves in the United States, as well as Britain, Europe and Japan. The combination of strong growth globally and the Fed's commitment to loose monetary policy should therefore, PIMCO argues, weaken the dollar.
Expectations of strong growth support the current bullish run in the equities market, and the investment manager remains overweight U.S. equities. Commodity prices, which move with inflation, may rise modestly, but those gains will be capped. (Reporting by Kate Duguid; Editing by Alden Bentley and Marguerita Choy)