What was the best-performing asset class in 2020? If you happen to suppose “tech shares” or “bitcoin”, suppose once more. As an alternative, because the Bridgewater hedge fund lately wrote to its purchasers, “among the many extra attention-grabbing and least recognised outcomes” of 2020 was that US inflation-linked bonds beat different belongings by delivering a 35 per cent return, on a risk-adjusted foundation, as traders hedged in opposition to inflation dangers.

This can be a notable straw within the wind. It may appear weird that anybody ought to fret about American inflation now. Information on Wednesday confirmed that annual US shopper worth inflation was a measly 1.4 per cent in December. Wage development can be weak, unemployment excessive and financial exercise dragged down by the pandemic. Even when development resumes in 2021, latest many years recommend that the dual forces of globalisation and digitisation ought to preserve costs in test. 

Most notably, the web has unleashed new international types of worth competitors for items, providers and labour. It might nicely proceed to take action, on condition that Covid-19 has accelerated the digital shift. At this time, virtually everybody has grow to be adept at on-line buying, whereas corporations have found many workers can work remotely. So the aggressive pressures that preserve a lid on inflation appear to be rife.

Nevertheless, the rationale why traders have rushed to hedge in opposition to inflation is because of a priority that inflation may show to be a “black swan” occasion, with a low-probability however high-impact danger. 

In recent times, most funding portfolios have been constructed on the belief that rates of interest and inflation will keep low indefinitely. Because of this if something rocks this consensus, there shall be a nasty market whiplash. Certainly, proper now, there are not less than three components that ought to give traders pause for thought.

The primary is short-term reflation risk. Though financial development is at the moment weak as a result of pandemic, the incoming administration of president-elect Joe Biden appears poised to unleash extra fiscal stimulus. If this hits the economic system because the Covid-19 vaccine turns into broadly out there, there is likely to be a surge in financial exercise later this yr.

If rising demand then collides with supply-side bottlenecks — which is probably going as a result of the lockdown has destroyed capability in some sectors — costs may bounce in some areas, particularly leisure and providers. Esther George, the pinnacle of the Kansas Federal Reserve warned as a lot this week.

Different Fed officers, such Lael Brainard, argue that any such worth jumps shall be non permanent. Possibly. However the second difficulty for traders to think about is that the structural components that stored inflation low in latest many years — notably globalisation and digitisation — could shift. As Charles Goodhart and Manoj Pradhan argue in a new book, demographic pressures in locations similar to China may create labour shortages and thus wage development. Elevated commerce protectionism may increase service and items costs, too. Globalisation’s latest previous is probably not a superb information to its future.

The third and maybe most essential difficulty is the stance of the US Federal Reserve. One other issue that stored US inflation expectations low in recent times was the sunny assumption that the Fed’s 2 per cent inflation goal left it dedicated to behave preemptively if inflationary pressures grew. However that assumption more and more appears wrong.

One motive is that Fed officers now say 2 per cent shouldn’t be a ceiling however a mean long-term goal, which means they could let inflation rise above 2 per cent for durations. One other is that political and financial pressures may make it more and more arduous for the Fed to behave pre-emptively, since any rise in rates of interest additionally will increase the price of servicing the federal government’s ever-swelling money owed.

“Within the previous regime the Fed was attempting to reach on time. Now they’re saying we aren’t going to reach on time however as a substitute . . . be late by design,” Invoice Dudley, former head of the New York Fed advised me. “When rates of interest begin going up, the debt-service downside will lastly come evident . . . You need to fear concerning the strain on the Fed to not tighten as a lot as they should.” 

In the long run, all which means that the possibilities of a future inflationary shock are rising too, as Mr Dudley and another Fed officers recognise. “We’re on this La La Land proper now the place the Fed’s quantitative easing is offering help for monetary markets [and] markets are simply not targeted on the top of QE,” Mr Dudley warns. “However in some unspecified time in the future the Fed must trace that it’s shifting into one other regime.” 

When that happens, “there could possibly be a taper tantrum”, provides Mr Dudley, referring to the 2013 market swings that occurred when Ben Bernanke, then Fed chair, gave the mildest of hints that the central financial institution may reduce, or taper, its QE programme. Certainly, there may be each probability that the following tantrum shall be orders of magnitude worse, on condition that the Fed has so explicitly inspired traders to guess on charges staying so low for not less than two extra years (which I think about to have been a mistake).

Fortunately, that danger in all probability lies sooner or later. The Fed’s tone remains to be dovish. However what’s right here now could be a shift in inflation chances from “very low” to “not so low”. Buyers are thus right to hedge their bets, nonetheless gloomy the information concerning the pandemic. In any case, one thing else we learnt in 2020 is that the unthinkable generally does grow to be unexpectedly actual.

gillian.tett@ft.com

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