Is it time to buy inflation breakevens?
- Performance for inflation-linked bonds has been positive since the start of the year
- Compared to the current inflation rate, breakevens are trading at a depressed level
- Beyond oil prices, stabilisation in economic growth outlook could boost inflation breakevens
The bond market has been on fire since the beginning of 2019. Interest rates are lower, and spreads are tighter thanks to the radical turnaround from all major central banks (from policy normalisation to easing mode) and inflation-linked bonds have enjoyed the ride.
Performance for inflation-linked bonds has been positive since the beginning of the year, thanks to their sensitivity to interest rates. However, a large share of the nominal government bond rally since January can be attributed to falling inflation expectations.
What does this mean for inflation breakevens?
Compared to the current rate of inflation, breakevens are left trading at a rather depressed level. Our expectation is that advanced economies should avoid a recession thanks to accommodative central bank policies, and therefore realised inflation should remain broadly stable.
Inflation breakevens look attractive from a valuation perspective. A strong rally would probably need a stabilisation in the macroeconomic outlook which could come from accommodative central bank policies. Short duration inflation-linked bonds could also benefit from low inflation breakevens and easier monetary policies.
Breakevens price in a depressed inflation
To assess market participants’ expectations of future inflation, it is useful to compare the level of so-called inflation breakevens to current inflation. This simple analysis makes sense as inflation has remained, and is expected to remain, broadly stable. This metric is telling us that over the coming five years, the market expects inflation to be only 1.65% per year in the US and 0.84% in the euro area. Current core inflation rates are 2.1% in the US and 1.1% in the euro area.
Is short-termism the issue?
A basic approach to assessing whether the market is optimistic or not on the future of inflation, is to compare what economists are saying about inflation prospects – typically one year ahead – and what the market is pricing. Again, this analysis would show that the market is expecting less inflation in the coming 5 or 10 years than economists are forecasting for the year ahead.
While this methodology may look simplistic, we believe it is appropriate because, since its launch in the 1990s, the inflation-linked bond market has shown little ability to efficiently forecast inflation over the medium-term and a high tendency to exacerbate short-term inflation moves.
In the chart below, we have plotted the zero coupon 10 years euro inflation swap (a good proxy of inflation breakeven) and euro area realised headline inflation. The fall of inflation breakevens seen since mid-2018, is also explained by the slowdown of year-on-year realised inflation that had nothing to do with deflation risks, but with near term oil price volatility instead.
Oil price rebound should be supportive in the near term
We believe the oil price rebound since the beginning of 2019 is a good indicator of where inflation breakevens are heading over the near term. In that sense, the recent deal between OPEC and Russia to extend production cuts could potentially remove a downside risk to inflation breakevens, and could be a positive signal for a long inflation breakeven position. However, what should really matter is economic growth.
Looking beyond oil prices
We believe economic growth is what matters for inflation expectations. Looking at what has been driving the most significant moves in inflation breakevens since 2015, we find that while oil was helping, it certainly wasn’t the main driver.
The table above summarises what has happened during episodes of rising breakevens and shows some interesting common features of inflation breakeven rallies.
Economic outlook matters
Inflation breakeven rallies have historically lasted between 2.5 and 11 months. Investors therefore need to time their inflation breakeven strategies well. The more solid the macroeconomic backdrop and the more aggressive the monetary policies, the greater and longer the inflation breakeven rally should be.
Finally, inflation breakeven moves are well correlated across the globe. While the magnitude would differ from one country to another, inflation breakevens direction has always been the same. This makes a global approach to inflation breakeven positioning relevant in our opinion.
Mind the timing
While timing will be important for long inflation breakeven positions, we believe short duration inflation-linked bonds also look attractive. A key feature of short-term inflation-linked bonds is their limited duration and sensitivity to inflation. Short duration inflation-linked bonds could benefit from more accommodative monetary policies, especially in the US as the Federal Reserve is potentially gearing-up towards rate cuts.
Short duration inflation-linked bonds also have the advantage of inflation breakevens being structurally lower at the front end of the curve, potentially making them more attractive from a valuation perspective.
What does all this mean for inflation breakevens?
We believe that adding long positions in inflation breakevens look increasingly attractive. Such a position should benefit from a stabilisation of economic growth prospects and accommodative monetary policies from central banks. Alternatively, short duration inflation-linked bonds could also potentially benefit from the low inflation breakeven and easier monetary policies.
 The spread between the nominal bond yield and the real yield of an inflation-linked bond from a single issuer
 Source: AXA IM, Bloomberg as at 15/07/2019. Levels of US and French five-year breakevens.
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