Jonathan Baltora, fund manager of the AXA WF Universal Inflation bonds comments on the implications of the latest Bank of England Inflation Report.
- Currency wars remain a valid theme – the self-fulfilling loop
- Inflation tends to disappoint where a currency has been strengthening – pushing the central bank on a more dovish path
- Some positive liquidity news in fixed income – volumes traded in US TIPS, where the data is available, is as high as ever 1
The Inflation Report from the Bank of England is shining some light on the prospects for the future of monetary policy in the UK and in essence the report is marginally hawkish overall. A year ago the market was close to fully pricing in a Q4 2014 rate hike, but low inflation has pushed rate hikes further into the future. This is yet more evidence that inflation targeting still rules.
Inflation targeting has survived the crisis and the late 2014 / early 2015 inflation slippage that has exacerbated deflation fears has played a great role driving bond yields lower. Current bond yield re-pricing is coming without inflation expectations tumbling, this is encouraging for central banks. Inflation currently remains low and rock-bottom levels have been reached in most countries. As oil prices have simply stopped falling, year over year inflation rates are set to move higher across the globe.
Currency wars also remain a very valid theme and it is a self-fulfilling loop: a central bank sees an improvement in its economy and plans to tighten monetary policy, as a result the currency rallies and in the subsequent year inflation starts to disappoint and the central bank has to postpone tightening. This is the story in the US and the UK over the last 2 years and in Australia since 2010.
The inflation linked bond market
Dedicated inflation-linked bond strategies are seeing inflows as oil prices have rebounded and as end-users are rushing to lock-in breakeven rates below central banks’ inflation targets.
While the bond market’s experience in May is comparable to 2013’s taper tantrum, the performance of inflation linked bonds has remained close to nominal government bonds. According to Barclays Inflation Linked bonds indices, euro inflation linked bonds and TIPS have underperformed nominal bonds by only 0.4% and 0.5% respectively, while UK linkers have outperformed gilts by 1.2%.
A significant difference with the 2013 sell-off is that oil prices have held steady while they were in free-fall back then. Because of inflation targeting and the ongoing currency wars, we believe that inflation tends to disappoint where a currency has been strengthening, therefore pushing the central bank onto a more dovish path. From an inflation-linked bonds perspective this also suggests that inflation-protection is attractive where currencies have been weakening.
As in every corner of the bond market, liquidity is not what it used to be, but there is some good news. Volumes traded in US TIPS, where the data is available, is as high as ever. We are seeing liquidity profiles changing from traditionally being available for every bond, to becoming more “on-the-run” centric, with the trading of older securities becoming much less active.