For inflation linked bond investors, the past three years have been difficult. During this time, nominal bond yields have collapsed in the wake of a rapidly falling oil price in the second half of 2014 and more recently in the face of fears over weak growth and negative interest rates, leading to outsized returns for long-dated investors.
The majority of the fall in yields has occurred from sharply lower breakeven inflation rates (future inflation expectations) rather than reduced real yields, which are trading at levels more than 50bps higher than the lows of 2013. As a result, breakeven inflation rates are in many cases trading at levels not seen since the deflation scare of 2002 (ignoring the financial crisis). Are future inflation forecasts as determined by bond markets too low?
Of course, there are many good reasons behind the concerns about deflation. Inflation is low across the developed world, mostly due to the collapse in the oil price since the summer of 2014. In addition, the oil price has been accompanied by weak commodity prices, with the Bloomberg Commodity Index currently trading at more than half of its value of mid-2011.
As a result, producer price data are also printing at multi-year lows. It is argued that the reduction in inflation and inflation expectations are the result of a change in the dynamics of supply and demand. On the supply side, the period of low interest rates in the West and higher projected global growth saw a huge amount of investment being deployed into emerging markets. This investment has turned into overcapacity which may take some years to unwind. On the demand side, a weak economic recovery that follows a global financial recession (in 2008-9) has led to weaker-than-expected demand.
It is likely, however, that inflation expectations may be trading too low and could rebound. Long-term inflation expectations appear to have been dominated by short-term movements in the oil price. Unless the oil price continues to fall from current levels, the base effect should see inflation rise. In addition, the recent rise in the oil price could see overall price levels rise from here. Wage growth could become an issue for some central bankers to worry about over the coming years. The unemployment rate in the US is approaching the low point of the previous economic cycle and the UK will be impacted by the new Living Wage.
Next, improvements in macroeconomic data and investor risk sentiment could see expectations rise. Finally, there are signs in the data that inflation is already a concern. Annual US core CPI (i.e. ex-food and energy) is already trading at 2.2% (March 2016) while the equivalent figure in the UK is 1.5%. In the UK, the recent weakness in Sterling combined with the potential for a further weakening could lead to higher inflation over the next couple of years. Overall, current inflation breakeven rates appear too cheap and the Asset Allocation Committee has decided to better position the portfolio for rising inflation expectations.
Ways to implement the trade
Two methods of playing the trades were discussed.
1. UK inflation linked gilts (ILGs). Seen as a simple, clean way of accessing the trade, ILGs provide exposure to falling real yields (if global growth rates further disappoint), rising inflation expectations (based on RPI inflation which is typically 1% higher than CPI) and some income.
2. US TIPS (Treasury Inflation Protected Securities). The argument for US “linkers” over the equivalent UK counterparts is the currency: the US dollar. Many investors feel that the US dollar is a natural risk-off currency and should benefit Sterling-denominated investors during periods of market stress (although the result of Brexit could cause a material binary outcome to cable). The US labour market could be the tightest of all of the major economies, potentially leading to rising wage demands.
Darren Ruane, head of Fixed Interest at Investec Wealth & Investment