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A common misperception of bond-adjacent investors is that inflation-protected bonds are a good thing to own during periods of rising inflation in the short term. They may prove better things to own than conventional unindexed bonds. And if you hold them to maturity, you should get the inflation protection you paid for. But if bonds puke, they’ll probably puke with the best of them.
But this makes them far from useless. For one thing, we can interrogate prices paid for these and conventional bonds to glean how bond investors view the world, and specifically any forthcoming inflation shock.
On Monday, Alphaville observed that oil market traders appeared to be discounting a short war, with the price of crude oil contracts for delivery in the next few months soaring, but longer-term contract prices being more muted. Since then, short-term contract prices have continued to rise:
We — along with the rest of the financial universe — would expect this to push inflation expectations higher everywhere. Because energy prices feed into pretty much everything, especially in energy-intensive economies like the US.
But it’s not like energy prices doubled or anyth . . . hold on
As European readers will know, natural gas prices have pretty much doubled. And it was soaring natural gas prices in Europe, and the various policy responses to this price shock, that accounted for much of the deviation in inflation shock suffered by consumers. Urgh. Meanwhile, the US natural gas futures curve remains largely untroubled, if you can call what looks like a panicky electrocardiogram untroubled.
So what do inflation markets make of all this? We’d expect traders’ short-term inflation expectations in the UK and Europe to have been pushed a fair bit higher, while the change in US inflation expectations to be a bit more muted.
And grabbing breakeven inflation rates from the US and UK inflation swap curves, this is exactly what we find. The energy shock is priced to be a bigger headache for UK households and monetary policymakers than it is for their American cousins:
What about Europe?
The market for euro-denominated inflation-linked bonds and swaps is less deep and liquid than it is in either the UK or US. And getting a read is complicated by European governments each being perceived by the market as having different levels of credit risk. But when we matched German, French and Italian government linkers against their nearest domestic benchmark bond, this is what we found:
Inflation expectations have risen, especially at the short end — and even more so than they have in the UK. How much weight we want to put on any signal from a single BTPS bond though is open to question.
But given the unanchoring of inflation expectations as the world reopened after Covid, we can see why traders are trimming their expectations for rate cuts this year.
Read the full article here