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Chasing yields as inflation rises

Chasing yields as inflation rises

As the results of the EU Referendum were announced on June 24, investors’ mood turned darker and as expectations for massive easing from the Bank of England (BoE) took centre stage, sterling depreciated sharply.

This will, we expect, lead to increased inflation, not just because import prices are predicted to soar, but also because the BoE has done nothing to oppose what is largely seen as a transitory shock.

Even low inflation makes a difference when nominal bond yields are so low.

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In summary, I think we will have lower yields for longer and higher inflation. 

In theory this is the perfect environment for inflation-linked bonds to perform well. 

This has effectively happened in the UK as UK inflation-linked bonds (gilts) have generated some of the best returns you can find in the fixed income sphere this year.

Inflation-linked gilts have  outperformed other inflation- linked bond markets as they have the longest average duration available and have also been lifted by rising inflation expectations.

It is not about Brexit, it is about inflation picking up globally as the drag from falling oil prices dissipates.

We still expect inflation to move closer to the Central Banks’ target around the end of 2016. This has been our view since the end of the first quarter of the year as oil prices started to stabilise. 

Modest







Our inflation scenario is modest, we expect US inflation to reach the level of underlying inflation (that is, inflation excluding food and oil) by the end of 2016 and to remain around this level into 2017.

This means US inflation could be approximately 2 per cent to 2.5 per cent next year (compared to 0.8 per cent annually currently). 

The picture is the same in other advanced economies, also due to the drag from falling oil prices. 

This suggests that euro area inflation would reach 1 per cent in 2017 (from 0.2 per cent currently).

In the UK, the fall in the currency means that we expect upward inflation surprises to kick-in next year.

These inflation forecasts do make a difference in a low-yield world as inflation is expected to print higher than government bond yields. 

You may think it is not an incredibly high inflation scenario and you are right.

In a nutshell we expect inflation to be close to Central Banks’ targets globally. Those economies that tend to have a current account deficit would experience relatively more (US, UK) and those with a positive current account balance would experience less (euro area, Japan). 

Even this relatively conservative inflation scenario can prove an issue as inflation will be running above the yield you can achieve in the government bond market.

Even a conservative inflation outlook does make a difference. Valuations are still attractive – the market expects less inflation over the next decade than what we expect for next year. 

Naturally, the size of the opportunity depends on what is already priced into the market. 

The 10-year US inflation break-even rate, which reflects the average annual inflation over the next decade priced into the market, currently trades at only 1.75 per cent.