Investors are gearing up for US inflation

As Bank of England chief economist Andy Haldane said: “For many years, the inflationary tiger slept,” though now the “combined effects of unprecedentedly large shocks, and unprecedentedly high degrees of policy support, have stirred it from its slumber”.

Like any good economist, however, he hedges his bets, as “it would be spuriously precise” to assign probabilities to either inflationary or deflationary outcomes.

A recovery from Covid is expected to unleash pent-up demand, as we all rush out on holiday, get our hair cut, and gorge on restaurant fare

That does not stop the Monetary Policy Committee, on which Haldane sits, estimating a one-in-three chance of inflation lying below zero, or above 4 per cent, at its two-year policy horizon. Perhaps this is the committee’s idea of ‘validly imprecise’.

Since the fourth quarter of 2020, the inflationary drums have been beating louder.

A recovery from Covid is expected to unleash pent-up demand, as we all rush out on holiday, get our hair cut, and gorge on restaurant fare. Asset prices have bounced back, the most dramatic example being that of oil, where WTI Crude went from almost minus $37 (£27) a barrel in April 2020 to more than $60 and climbing.

Then there is the vast government spending to support the economy. The US has spent 30 per cent of US GDP on Covid support, compared to 5 per cent in the aftermath of the global financial crisis. And there is more to come, with the US rolling out a $1.92tn recovery plan.

However, this side of the pond, there is not much sign of inflation yet, as you can see from the chart below. It is ticking up, but from a very low base.

Writing in the Financial Times, Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, warned “higher inflation is coming, and it will hit bondholders”.

Inflation reduces the real value of fixed income streams, so it is bad for bond investors. “It will be the Treasury bondholder, through rising inflation, who will be paying for the unprecedented fiscal and monetary stimulus over the past year,” said Siegel.

Investors can respond to this through a combination of cutting bond exposure, shortening duration, and switching from conventional to inflation-linked bonds. The broad rally following last April’s collapse was followed by a degree of caution in September as money went into longer-duration bond funds.

For much of 2020, governments and central banks were firefighting the pandemic, so that is no surprise: back in September, few were fretting about inflation, bounce or no bounce. Then, the end was far from nigh, pandemic-wise, and Joe Biden was still nowhere near the White House. Things have changed – but have investor expectations?

That certainly seems to be the case in the US. Refinitiv Lipper research for the US market showed net flows into inflation-protected bonds funds for both January (+$5.9bn) and February (+$3.6bn). These were record amounts going back 2002, when this classification was created.

The UK seems rather more sanguine about the prospects of domestic inflation. There is no sign that investors are bailing out of bonds.

If investors are hunkering down for a significant uptick in inflation, you would expect to see flows toward inflation-linked bond funds

UK fixed income flows for the quarter to the end of February 2021 were £5.1bn. The 10-year quarterly average is £3.2bn, so flows are significantly up. This is not the bond bloodbath that many have been expecting. Or, if it is, no one has seen fit to tell fund buyers.

How does this pan out when we look at more granular bond classifications? If investors are hunkering down for a significant uptick in inflation, you would expect to see flows toward inflation-linked bond funds, which would give a measure of inflation protection. And, as illustrated, that is indeed what US investors are doing.  

The chart above tells an interesting story. Over four years, flows into bond GBP inflation-linked funds peak in the three months ending May 2017, at £1.37bn. This is at a time when inflation is climbing relatively steeply, to top out in the autumn of 2017 at 2.8 per cent (see chart one).

As UK CPI declines thereafter, flows mute and eventually go negative. Over this period, you have to squint to see US linker flows. They become meaningfully positive as UK inflation continues to trend down, while US inflation stays around the 2 per cent mark. It is also at a point, from late 2018, when former US President Trump got into a public row with the Federal Reserve about raising rates.

So far, so much ancient history. But it does show us that UK investors were behaving rationally in moving their money out of UK linkers while buying US ones as US and UK base and inflation rates diverged.

So, what is happening now? Since the summer, both US and UK linker flows have turned positive, indicating that UK investors expect inflation.

But they are expecting it much more – if these figures tell us anything – from the US (£1.77bn versus £700m for GBP-denominated inflation-linked bonds). The current trend is unusual, as there has been only one three-month period over the past decade that US dollar flows exceeded sterling flows when both were positive. Bond US dollar inflation-linked flows are normally a fraction of their sterling counterparts (remember, we are just talking about UK investors here).

The inference, then, is that UK investors agree with their US counterparts, and expect to see US inflation. They expect it less, or later, in the UK.

What is not clear is whether investors are making a bet that the UK has less to fear from inflation, making sterling bonds a better bet, or whether inflation is just going to feed through at a slower rate. Either way, it could support continuing flows to sterling bonds over the coming months.

Dewi John is head of research, UK & Ireland, at Refinitiv Lipper