Bank of EnglandNov 22 2016

Chasing yields as inflation rises

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Chasing yields as inflation rises

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.

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.

This compares with the current core inflation rate currently at 2.2 per cent (a good proxy for next year’s inflation). 

Overpaying







This is a significant difference, as historically the market was overpaying in order to be protected against future inflation, but today it is the opposite and hence we see this as an opportunity. Still, the market may not believe in inflation until it sees it.

What is true for the US is also true in the UK and the euro area. 

This is not only about inflation picking up, but also about inflation expectations at historically low levels at the time when inflation will accelerate.

To us, this is not purely a US or Brexit trade, it is a global one, as inflation and inflation expectations are strongly correlated across countries.

Our scenario for an US inflation rate being close to the Federal Reserve’s target is near to what has been the effective rate of inflation since the year 2000. 

Put this way, it may not sound impressive, but this means prices have been increasing more than 40 per cent in the US since the beginning of the millennium and this has increased the value of inflation linked bond coupons.

As we expect inflation to be higher than long-term yields, inflation indexation is our preferred strategy. 

On top of this and thanks to the strong bond rally since the beginning of the year, the average real yield in short duration inflation linked bonds is now higher than in ‘all maturities’ inflation linked bonds. 

Inflation indexing strategies like global inflation bonds with short durations should not be overlooked in this environment.

The question is not so much where inflation expectations are headed but instead how to capture inflation in your investments. We view inflation linked bonds as a trade-off between inflation and duration.

If you buy an inflation-linked bond maturing in one or 30 years the inflation accrual is the same. 

So if you are in a pension fund you may need those ultra-long linkers that will serve the purpose of duration and inflation hedging.

If you are an investor wishing to protect the value of your cash from being eroded by inflation then short duration inflation-linked bonds may be what you are looking for – their performance has historically been close to inflation itself.

This is exciting even with low inflation, because long‑term interest rates are even lower than the low inflation we are expecting for next year.

Jonathan Baltora is manager of the AXA WF Global Inflation Short Duration fund 

Key points







• We will have lower yields for longer and higher inflation.

• US inflation could be approximately 2 per cent next year.

• Global inflation bonds with short durations should not be overlooked in this environment.