Notably, energy costs have been a key driver of rising prices across industries, including transportation, manufacturing and agriculture. Crude oil prices surged in 2021 before peaking in early March 2022 at around US$120 per barrel for West Texas Intermediate (WTI). Now, just over a year later, the WTI price is hovering around US$75, not far above its prepandemic level. We expect to see the benefits from lower energy input prices ripple across a wide range of CPI constituents.
Changes in Mortgage Rates Matter More in Europe
Homeowners’ sensitivity to rate increases also drive changes in UK and EU inflation relative to the US. While 30-year fixed-rate mortgages prevail in the US, across Europe it’s more typical to have shorter-term fixes, or floating-rate mortgages.
In the UK, for example, around 15% of home-owners have variable-rate loans, while a further 17% have fixed-rate loans due to be remortgaged this year at higher rates, with the peak reset months falling in April through June. Most of these home-owners last borrowed at rates below 2% (according to the UK’s Office for National Statistics) and will need to renew at rates up to three times higher. Thus, the shock to household finances from higher monthly mortgage payments will impact consumer spending and economic activity far more in the UK and EU than in the US.
Starting from higher levels, inflation should fall more steeply in the UK and Europe this year than in the US, we believe: UK CPI, for instance, may fall from 10% to 5%. But while markets want to believe in a lower inflation scenario, bond prices will likely only react when better CPI numbers actually start to come through. By that stage, we think tomorrow’s problem will be starting to manifest, in the form of weakening economies and labor markets.
Consider Downside—as Well as Upside—Risks
What could go wrong with this thesis? Against a volatile global backdrop and with rates still rising, it’s possible we could face a renewed crisis in the banking sector. However, this would likely benefit longer-dated sovereign bonds. The fallout from a turn for the worse in Ukraine or other troubled areas would be harder to read. And a renewed spike in energy prices would revive inflationary pressures.
Overall, we believe there is now a stronger case for adding duration across most bond markets. We think the hiking cycle is nearing its end and, once central banks pause their rate rises, investors will anticipate the cuts that typically follow on a three-to six-month timeline. The UK and EU look to us to have the most upside.
