Where inflation is headed and what it means for investors

Disinflation trends such as slowing wage growth are important because they’re positive developments and act as key indicators when central banks are making rate decisions. Inflation progress should lead central banks to be less worried about second-wave inflation risks, less focussed on recent inflation figures and more forward looking.

The shifting mindset of central banks from current inflation risks to growth development going forward reinforces the view that an important global rate-cutting cycles have started. The Bank of Canada announced its first rate cut in June and the U.S. Federal Reserve cut rates for the first time on September 18, 2024. But the extent of rate cuts central banks can deliver remains uncertain. Markets are pricing in significant reductions, which is in line with a return to a neutral stance within a year. Pricing a return to a neutral stance implies both a sustained return of inflation to 2% and several quarters of weak growth, given the economy is running above its potential. While we anticipate central banks to make cuts, we’re skeptical about their willingness to reduce rates as aggressively as bond markets anticipate, because the economy is more resilient than suggested.

We expect interest rate cuts will unleash sizeable pent-up demand. We foresee the output gap remaining in positive territory and inflation persisting moderately above target levels. Within developed markets, we expect policy rates to remain 50 to 100 basis points (bps) above neutral rates in 12 months.

Overall, investors are facing a constructive environment for risky assets, characterised by faster disinflation, policy support from rate cuts and economic growth remaining surprisingly resilient. We project a positive medium-term investment landscape for various sectors including housing, public infrastructure and technology.

For government bond yields, we anticipate limited downside —making the outlook less attractive. Yields have already declined to levels near or below the lower end of the range we outlined in our last quarterly Perspectives. While ongoing disinflation should exert downward pressure on yields, we expect resilient growth to provide an offset. We anticipate the correlation between yields and inflation will continue to remain unusually low. That said, government bonds remain essential in a diversified investment portfolio as a hedge against a more pronounced economic slowdown — a scenario that would result in a higher correlation between yields and inflation.