A great bounce in inflation breakevens

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Over the past few weeks we have witnessed a meaningful bounce in inflation breakevens in the UK, Europe and the US – in other words, in the difference between the yield on bonds whose interest payments are linked to inflation and the yields on bonds whose payouts are not.

When breakevens are rising, it is a signal that the fixed income market is anticipating higher inflation than has been priced in. It also means that inflation linked bonds are outperforming conventional bonds. In the UK, the linker gilt of 2016 has outperformed the conventional gilt by 0.45-0.5 percentage points in yield terms since the start of this year.

Why have the bond markets started to price in higher levels of inflation? There is an element of geopolitical risk that is currently affecting the oil price, which feeds into the inflation baskets in a plethora of forms.

In the US, where oil is taxed for less than in the UK of Europe, inflation is far more sensitive to changes in the oil price. However, oil is not the major culprit here.

Perhaps rising breakevens owe to fears around money creation? In Europe, at the end of 2011 lending between banks was completely dysfunctional, and we were entering a deflationary spiral. But the European Central Bank’s recent long term refinancing operation (LTRO) has added somewhere in the region of €1trn (£830bn) to banks’ balance sheets over the last few months, the interbank market has been showing signs of being slightly less dysfunctional, and the risks of deflation feel for the moment substantially reduced.

In the UK, the mechanism of quantitative easing boosted the prices of conventional gilts more than index linked gilts, as the Bank of England did not purchase linkers directly.

This artificially suppressed the relationship between the conventional gilt and the linker - the breakeven - at exactly the moment when money creation ought to have seen higher inflation risks priced in.

The strong performance of index-linked gilts in the UK owes to one of two things: a fear that improved economic data means we are closer to the end of quantitative easing than the beginning, so the artificial source of demand for gilts is not going to be in the market for much longer; or a decision that we are not going into a disinflationary or deflationary economy, and are more likely to see inflation hit the Bank of England’s target or exceed it.

It is worth thinking about the levels of five year breakevens in particular. In the UK the bond market is expecting inflation to average 2.8 per cent a year for the next five years.