We remain of the view that the policy-induced recession we are forecasting will be highly disinflationary. However, prolonged periods of elevated inflation can lead to greater persistence if firms and households start placing more weight on past inflation rather than central bank targets when forming their expectations. A “sticky inflation” scenario would lead to a higher ‘fair value’ for yields than in our base case.

  • Although the softer October US inflation print triggered a bond market rally, the speed with which underlying inflation will moderate through 2023 remains very uncertain. 

  • Stable medium-term inflation expectations signal that markets still have faith in central banks’ ability and willingness to tame inflation. 

  • However, long periods of elevated inflation can alter price setting behaviour, as firms and households increasingly assume that high inflation will persist. 

  • Forecasting these behavioural changes in real time is difficult, so we maintain our base case that a policy induced recession will prove very disinflationary. 

  • But we have added a new ‘sticky inflation’ scenario, in which inflation comes down much more gradually amidst the recession and policy rates have a higher peak and higher trough. 

  • In this scenario, front-end bonds will have to reprice to higher yields over the next few months, while the fair value for bond yields across the curve would still be pulled down in H2 2023, albeit to a higher terminal level. 

  • We expect bond prices to be volatile as market participants remain sensitive to short-term news about future inflation and the consequences for policy. 

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