Since last year, the market has been absorbed into the reflation theme. This has pushed inflation breakevens to their highest levels in 5 years. Are those higher inflation breakevens justified and will a new environment where inflation plays a bigger role change how investors use inflation-linked bonds within their portfolios?
Why are inflation expectations on the rise?
Currently, we observe that cyclical and structural factors are aligned, and over a long horizon this environment will be inflationary.
Monetary policy: Central banks have and are moving towards being more tolerant of inflation overshooting their targets, whilst at the same time they have begun targeting actual inflation instead of their model forecasts, as well as relying less on model based slack indicators. Fiscal policy: Governments are shifting away from strict fiscal discipline towards regimes where fiscal spending is considered as an effective stimulative tool.
Demographics: Global demographics are changing and there will be more retired people in both emerging and developed countries. As more and more people retire and permanently leave the workforce, the global labour abundance that has existed in the last 40 years will turn into a labour shortfall. This is inflationary^. Slowbalisation: Globalisation is slowing due to a desire from companies to diversify supply chains, rising populism originating from greater inequality, and finally from trade and technology wars.
Thus, we see the risk of inflation as increasing. Furthermore, these changes within the economic environment are not reverting any time soon, and the factors that have pushed the economy are here to stay. These developments alone are a good opportunity to look further into inflation – to better understand what is happening.
Why are investors suddenly willing to pay more for inflation protection?
Up until the great financial crisis, investors were willing to pay a premium to own inflation-linked bonds compared to nominal bonds, in order to be protected against potential rapid inflation rises. This was likely due to investors having the 1970-1980 supply-driven crises and high inflation in the back of their minds. The great financial crisis then extinguished any fear that the economy would soon run into a supply-driven crisis with high inflation. When investors lose that fear, inflation-linked bonds are less likely to trade at a premium to nominal bonds, and are more likely to be priced, traded and behave like a risky asset in demand-driven crises, where investors don’t place much importance on inflation protection. Therefore it was natural to ask for a discount to nominal bonds. In reality this is how inflation-linked bonds have been priced since the great financial crisis. We now see this as changing, as the changing cyclical and structural factors enter investors mind-sets.
What do we do from here?
The changing inflation landscape, some of it visualized by the present reflation theme, therefore has a deeper consequence. Whilst we can all hunt for the next 20bp in inflation breakevens, it is more relevant instead to take a broader risk view on inflation and ensure that portfolios are well protected against rising inflation on a longer horizon.
^Goodhart, Charles, and Manoj Pradhan. The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival. Palgrave Macmillan, 2020.
Nicolaj Holm-Christiansen: firstname.lastname@example.org +45 2978 3161
Adam Lindeloff Knudsen: email@example.com +453010 2315
| This article is based on information provided by Danske Bank (sponsored content).
| All opinions expressed are those of the author.
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