A great bounce in inflation breakevens

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.

Remember though that this is retail prices index inflation, which historically has averaged 0.8 percentage points more than the consumer prices index equivalent per year. If we assume this historical relationship holds, then this five-year breakeven implies consumer prices index inflation will be bang on the Bank’s target of 2 per cent.

So on this basis the breakeven does not make inflation-linked bonds look expensive at all. Considering the five-year breakeven in Europe, which is currently 1.6 percentage points, this is still pricing in inflation on average undershooting the target of roughly 1.8 per cent for the next five years.

Inflation target

With money being created aggressively, surely the risks are skewed to the upside? In fact, only the US market is pricing in inflation to be above target for the next five years.

This is the correct side of the inflation target for linkers to be valued at, and there is a good chance the UK and European markets start to move towards this US dynamic. Why? First, because of the ultra low interest rates and ultra accommodative monetary stance at the European Central Bank, the Bank of England and the Federal Reserve. And also because of the large scale money creation we have seen in all three markets and have discussed briefly above. But most importantly, the three central banks in question all have a clear and visible inflationary bias.

They would rather have inflation than deflation - rightly. But now they are showing a propensity to favour above-target inflation over below-target inflation.

This is tantamount to a change in the inflation targets - and this must see investors charge higher premiums for inflationary risks.

Ben Lord is fixed income fund manager at M&G Investments