The inflation advantage: Rebuilding defence in bond portfolios

Evidence is mounting that the US may be in a new inflationary regime, where repeated supply-side shocks - including the pandemic, war in Ukraine and higher tariffs - together with a sharp slowdown
in US immigration, are contributing to persistently above-target core US inflation.

The Federal Reserve (the Fed) now faces an increasingly delicate balancing act between its dual mandates of maximum employment and price stability. Growing concerns about the politicisation of the Fed and the integrity of other US institutions raise the risk that inflation expectations could become de-anchored over time.

Across the G10 — and Australia — there are recent signs that the post-pandemic disinflationary impulse is stalling. In this environment, bonds may no longer rally automatically at the first sign of labour market weakness. A more cautious Fed or higher inflation risk premiums on long-end bonds could challenge some of the traditional portfolio benefits of fixed income during downturns.

Despite these headwinds, we believe fixed income remains a core defensive asset. However, achieving resilience in this new environment requires investors to consider broadening their fixed income toolkit and applying more sophisticated strategies to improve defensiveness and protection. QIC’s fixed income process employs three key levers — interest rates, credit spread duration, and inflation duration — designed to provide improved diversification and defensive benefits across different market regimes.

Why inflation protection matters now

Today, US inflation remains higher than pre-pandemic levels and progress towards the Fed’s 2% core personal consumption expenditure (PCE) deflator target has recently stalled (refer Figure 1). Tariff increases are widely expected to further add to US inflation and recent Federal Reserve business liaison suggests the pass-through from tariffs to prices is likely to be protracted.¹ The sharp slowdown in US undocumented immigration since mid-2024 also adds to upside inflation risks by reducing labour supply growth. 

A deep understanding of the macroeconomic drivers of inflation markets is also required. This includes forward looking inflation expectations, inflation risk premium and the correlations to oil and risk markets.