Lead — The desk sees inflation-linked bonds as increasingly attractive given the current geopolitical tensions and their impact on commodity prices, which have surged since the onset of hostilities in the Middle East. Per the full note from BofA Global Research, the inflation markets are responding to these dynamics, with a notable focus on break-even inflation rates and real yields. The desk emphasizes that the current environment may favor TIPS as a hedge against inflation, particularly in a stagflationary context. With no high-impact events on the calendar, traders should remain vigilant about market movements influenced by inflation expectations.
What the desk is arguing
BofA Global Research sees opportunities in inflation markets following the pronounced commodity price swings since the start of hostilities in the Middle East. They note that market dynamics have translated into real yields, breakevens, and inflation swaps in sometimes surprising ways, and they flag interesting opportunities and developments for investors.
Where it sits in our coverage
We have no explicit internal coverage on inflation markets or the specific currencies for this piece. However, our general consensus leans toward a cautious bullish stance on inflation hedges given the geopolitical backdrop, with a firm spread implying modest upside in breakevens.
How other firms see it
No other firms are cited in the source material. We have no external firm stances to report.
Key takeaways
01Commodity price swings from Middle East hostilities create opportunities in inflation markets.
02BofA highlights surprising dynamics in real yields, breakevens, and inflation swaps.
03Investors should monitor inflation-linked instruments for potential trades.
Market implications
The commentary suggests that inflation markets may offer attractive entry points given the current volatility. Increased geopolitical risk could lead to higher inflation expectations and support breakevens and inflation swaps.
Risks to this view
Key risks include a de-escalation of Middle East tensions, which could reverse commodity price gains and reduce inflation expectations. Additionally, central bank policy responses could dampen inflation premium.
Hello, and welcome to Global Research Unlocked, the interest rate and effects series. This podcast is based on our weekly client conference call where our strategists along with guests from other parts of BYA Global Research discuss the most topical and pressing questions faced by our market. I'm Ralf Preusser, head of Global G10 rates and effects strategy.
Today's Friday, 17th of April, I'm joined today by Mark Caperton, head of Inflation Link Research, and Megan Swiber from our U.S. rate strategy team. Thank you both for joining, first of all. Mark, let's kick off with you.
I don't want to point out quite how long you have been covering linker markets, but to those uninitiated, inflation-linked bonds, commonly called linkers, what are they? Hi, Ralf. Yes, in straightforward terms, they are normally government bonds where the cash flows, i.e. the coupon and principal are adjusted for changes in the price index, normally the CPI, over the life of the bond.
So, for instance, we've got a 10-year TIPS issue redeeming in July, which will have about a 37% increase in the price index over the life of the bond, so that bond will have an uplifted redemption value of 137, yeah, it'll be 37%. On inflation. Great.
Thank you. So, what is this market, and who issues them? It's now about a $4 trillion market, $3 trillion in the developed market issuers, so the likes of the U.S., which is 50% of the developed market, the U.K., the Eurozone, country issuers, and then there's about a trillion of emerging market linkers, particularly Brazil and Mexico.
What's the interest for investors? Why do they buy them? Well, there are a bunch of reasons, but let's focus on the big one, and that is that you can't take it with you.
The only purpose of saving is to defer consumption for yourself when you retire or your dependents, and so you're interested in the future purchasing power, the future real value of your savings, and these instruments protect the real value of your savings. I guess equally importantly, what's the interest in governments to issue them? For a normal economic cycle, in the good times, when the economy is booming, government revenues are strong.
Then when economies are weak, government revenues suffer. Similarly, with inflationary bonds, inflation tends to be stronger cyclically in the boom times and weaker cyclically in the depressed times, so there's what they call a fiscal hedge. You can think of the assets of the state, land and buildings as real, and the future cash flows, revenues, income tax, et cetera, are correlated with inflation.
It's the fiscal hedge story. So why is it that some governments have stopped issuing or at least scaled back their link programs? What's prompted the rethink?
As a kind of link market specialist, it's sad to see particularly the likes of Canada disappear. Canada stopped issuing then within the Eurozone. Germany stopped issuing.
Sweden has scaled back its program dramatically. Even the UK has scaled back the proportion of its annual issuance done in linkers. It's really because of concerns, A, that the fiscal hedge doesn't seem to be working very well in the kind of stagflation time we saw through COVID, and I guess to some extent we're seeing now because, of course, in a sort of stagflation environment, inflation goes up, but the economy is suffering, so fiscal revenues suffer.
The awful example for the UK, which is, I guess, the most glaring example because it's got a big share of inflationary bonds, and also it suffered very high inflation. So in the 2022-23 fiscal year, the interest bill of the government was about 100 billion pounds, but two-thirds of that was the inflation indexation uplift on the link liabilities, so quite a painful problem. Thank you.
One of the phrases that we always hear when we talk about linkers is break-even inflation rates. How should we think about those? Break-even inflation is the difference between the yield on a nominal bond and the real yield on the linker of a similar maturity.
So really, you can think of it as it's the inflation rate which will equate returns for both the TIPS issue in the U.S., the inflationary bond issue, and the nominal comparator of the same maturity. How should we think about inflation swaps in that context? Yeah, I mean, inflation swaps are a really very straightforward instrument.
It's a price on expected average inflation over the life of the swap. So for instance, if you see a five-year inflation swap price of, say, 2.5%, then there's only one cash flow exchange, that maturity, where the person who's long inflation receives the change in the inflation index over the life of the bond, and the counterpart receives 2.5% compounded for five years. So yes, there's a simple difference whether cumulative inflation that you experience has been above or below the price at outset.
Megan, there's significant differences between these two measures given different indications of inflation expectations, especially when you start looking at shorter maturity bonds and swaps. What's going on and which measure should we trust? Sure, Ralph.
So when looking at this, there's three things to remember. So first is that there is always a basis between inflation swaps and break-even inflation. And that's because there's really no natural payer of floating inflation in the inflation swaps contract.
So that pay rate on inflation will always be higher for an inflation swap than on a break-even inflation that you're calculating from the cash market. And the second important thing to keep in mind here is that yields in the cash market can move around a lot when a new benchmark rolls in with a different seasonality characteristic around maturity. And even just over the past couple weeks in the US, we saw a big move in the generic two-year break-even rate when we moved from the April to July maturity.
The third thing that I think everyone needs to keep in mind, especially right now, is carry. We're in a very favorable carry period for TIPS right now, which means that you should be seeing, on just your average day, shorter tenor break-even inflation move down notably without any change in market view on inflation expectations. Carry just simply matters a lot more for shorter tenor yields when you're closer to maturity.
What we tend to focus on for daily tracking and trying to understand the decomposition of change in the nominal rate, breaking it down into inflation and real yields, is the inflation swap market because of that fact, as Mark outlined, that you're constantly looking at a rolling year-over-year rate when you're focused on inflation swaps. It's a better indicator to use when trying to understand price action. Great.
Thank you. Now, in the primer that you guys put out on inflation markets, you talk about how different asset classes fare in different economic scenarios, whether they're good, bad for real yields, good or bad for break-evens. And obviously, one of the terms that actually both of you, I think, have referred to already is that of stagflation, which is one that's being talked about a lot at the moment because of what's going on in the Middle East.
So intuitively, how should we think about what stagflation means for linkers? It should intuitively mean lower real yields, Ralph. And that's because we have the uplift in inflation compensations coming from spike in oil prices or spike in good prices, something that's more supply-driven rather than demand-driven.
And that's usually what we're thinking about when you get these big stagflationary shocks or as Powell said, we're not in stagflation period yet, but the Fed is feeling that conflict within their mandate. That gives the Fed some capacity to both look through some of the more supply-driven inflation, but it also challenges growth, it challenges consumer behavior. So you should be pricing or expecting a lower real yield relative to that higher inflation compensation number.
And how has that panned out in the U.S. in this current episode? Throughout this episode, Ralph, real yields have actually moved up. And this is quite inconsistent with the normal beta that we see real yields exhibit to oil.
Specifically at the front end and belly of the curve, you would expect that when we see oil move up to the same degree that it has over this period, we should be seeing inflation compensation, of course, move up, but should be seeing real yields be relatively flat to actually move lower in these types of environments. So there is a strong contrast between what we've seen with real yields moving higher versus what we would typically observe both from a macro understanding of fundamentals and then just what history tells us to. Thank you.
And how does that compare to what's been happening in the Eurozone in the U.K., Mark? Yeah, very similar. I mean, we've seen a bigger inflation moves in the Eurozone and the U.K., but real yields have also moved up, especially if you look at kind of forward real rates.
So five-year, five-year real rates and beyond in the Eurozone and the U.K. And I think what is happening here is that, yes, the markets think about the depressing effect on real yields from the growth threat from this conflict. The market is also worrying about the possibility that, hey, if we're going to get repeated shocks that are inflationary, then perhaps central banks need higher real policy rates to lean against those shocks.
But I suppose more importantly is that the market is worried about the fiscal consequences of the damage to growth and also the prospective increase in defense spending that we face in the future. Thanks, Mark. Now, you touched upon the fact that break-evens have gone up more in Europe than in the U.S.
Why is that, Megan? In the U.S., spot inflation swaps have lagged their beta to oil beyond the very front end of the curve. And this is because forwards, in particular the Fed's favorite five-year, five-year, have actually fallen alongside this uptick that we've seen in oil prices.
And that is unusual. In the U.S., it's been a story of a much flatter inflation curve with front end moving higher, across the remainder of the curve, really lagging the move that we would see on oil. And really, that's been because we've seen a compression in the forwards here.
If we look at the eurozone of the U.K. by comparison, I think part of the story is obviously the proximity to this in terms of the greater impact on European energy prices, natural gas especially, and the fact that, obviously, the U.S. is energy independent, whereas the eurozone isn't. In the U.K., there's a peculiar additional feature, I guess. Inflation rates in the U.K., break-even rates, forward break-even rates, have gone up more in the U.K.
I suppose a little bit of this is likely to be because the market sees the U.K. as more prone to inflation, I guess, after the experience through COVID, et cetera. But I think another part of the story here is there's been a very profound scarcity of inflation-linked issuance for the past four months. The Debt Management Office got ahead of the program and then cut down on linker issuance.
So we've had only like a billion and a half of inflation-linked bond supply for the past four months. It's a kind of supply starvation issue in the U.K. that's also lifting break-even rates. At the same time, re-yields have gone up more in the U.S. than they did in the eurozone.
Megan, what's happened? Well, in general, the market is telling us a pretty inconsistent story here. We think that the move higher that we've seen in belly re-yields is the market saying, OK, this means more aggressive Fed relative to more elevated inflation.
But at the further part of the curve in five-year space, the market's telling us that, indeed, this is a negative shock to longer-term inflation expectations. So there is definitely some inconsistency here. And this is why we think that some of the best positions for trading Fed mandate, for creating this dual mandate that we have as the Fed between unemployment and inflation, is through the inflation market, right?
Fading the uptick that we've seen in belly re-yields, which are inconsistent with the stat inflation narrative from a macro perspective, inconsistent with what we see historically between the beta between oil and re-yields. And then, of course, the compression that we've seen in longer-term inflation, which in our view is really one of the only things here that is going to get the Fed to put hikes meaningfully on the table, is if these longer-term inflation expectations begin to show signs of unanchoring. And certainly, they have not in the US.
We're not seeing that from survey-based measures. And indeed, if you look at market-based measures, those have moved lower during this past conflict. And Mark, what about the euro side of this going?
Yeah, real yields haven't moved up as much, at least as the US. And that's particularly noticeable in the kind of forward real rates. But they have moved up.
And I think that perhaps part of the better performance relates to the fact that it's a supply-demand thing. Overall supply is lighter in the eurozone than in the US in inflation-linked products. It's really down to issuance from France and Italy.
And in a thinner market, the bid for inflation has actually been supported for bonds on a real-yield basis in a relatively thin market. There's a natural real money investor bid for inflation-linked hedging in the eurozone, perhaps to a greater extent than in the US. Thank you, Mark.
Thank you, Megan. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.