Breakdown in ‘breakevens’ holes inflation buffer
If sky-high inflation is indeed rolling over as central banks get tough and recession looms, an already horrible year for investors in inflation-protected securities could get worse.
Markets are on tenterhooks again ahead of the critical U.S. consumer price inflation reading for July due later on Wednesday.
And many suspect forecasts for a retreat of 40-year high inflation from above 9% will underscore the ‘peak inflation’ narrative that has re-surfaced since mid-year and buoyed all markets by stoking hopes of ‘peak rates’ on the horizon.
The drop in energy, food, metals and shipping prices through July and into August has only encouraged that belief. Brent crude LCOc1, wheat Wv1 and copper CMCU3 futures as well as the Baltic Freight dry shipping prices are all back to pre-Ukraine war levels.
And the icing on the cake has been a remarkable decline in U.S. household and market gauges of long-term inflation expectations toward the 2% targets aimed at by the Federal Reserve and other central banks.
The supposition is easing supply-side strains flagged by the commodity price recoil will combine with the demand hit from oncoming recessions in the United States and Europe to puncture inflation rates and allow the central banks to ease off the monetary brake.
If that played out, could it call time on the scramble for inflation-protected bonds that’s defined much of the post-pandemic period?
Mutual fund data captured by Bank of America shows four consecutive weeks of outflows from these so-called ‘linker’ funds.
Matthew Hornbach’s macro markets team at Morgan Stanley showed this week that it has already been a lousy year for linkers even though inflation across the major economies has continually surprised to the upside all year.
In a note describing linkers as “total return stinkers” this year, they tease out the reasons they didn’t perform just when the fundamental inflation picture seemed to play right into their hands.
Caught in the slipstream of the first-half wipeout in most all stocks and bonds, total returns on U.S. Treasury inflation-protected securities are down 5% so far this year and the global index equivalent is down a whopping 14% – wiping out nearly all their post-pandemic gains.
The main factor has been their relatively long duration – the interest rate sensitivity of underlying bond prices tied to long maturities. As a result, they got whacked along with regular bonds by rising interest rates, higher real yields and the policy push to stamp on inflation at last – even though it has mostly exceeded prior forecasts.
As Hornbach points out, linkers perform best when inflation exceeds what’s already priced but when real yields also remain low – as they did in 2021 – and reflect policy settings likely to allow inflation to accelerate.
But there are also less price-sensitive investors who simply opt for ‘safe’ inflation protection over potentially larger losses on underlying bonds. For them, the basic rule of thumb is linkers will outperform when there’s a rise in breakeven rates – or the yield gap between nominal and inflation-protected bonds seen as a proxy for market inflation expectations.
But even as headline U.S. CPI inflation has surprised by climbing more than two percentage points this year to more than 9%, the 10-year U.S. inflation breakevens are basically unchanged from January at less than 2.5%.
Commodity prices – especially in this acutely energy and food supply crisis – have instead proven a much better gauge of where breakevens and inflation expectations are going than incoming headline inflation surprises themselves, it seems.
“The best hedge for higher inflation in this cycle – the one that generated the highest, unlevered total returns – hasn’t been inflation-linked bonds, but a basket of commodities,” the Morgan Stanley team wrote, adding food and energy’s combined contribution of about a third to headline CPI inflation rate this year was more than at any point since 1974.
At this point the argument, like so much else in world markets right now, all gets a little circular again. In essence, the more resolute central bankers are in fighting inflation, the less you want to be in linkers.
Hornbach and Co say that for all that energy and food led the inflation spike, core inflation rates are now high and rising too. If recession does not follow quickly, then high core rates may ultimately seal the fate of linkers by goading central banks to guide toward even higher peak rates than priced.
Others just think the markets have simply got the inflation outlook all wrong.
Jean Boivin, Head of BlackRock Investment Institute and former Bank of Canada deputy governor, told Reuters Global Markets Forum on Tuesday that inflation protection remained attractive.
“Market pricing of inflation is not in line with our views, so (there are) opportunities in inflation-linked bonds.”
Source: Reuters (by Mike Dolan, Twitter: @reutersMikeD; Editing by Emelia Sithole-Matarise)