One of the problems with a blog focused on interest rates is that bond markets can settle into rather uneventful long-term trading momentum. This has been the case for US inflation-indexed bonds, at least from a strategic perspective. In other words, given a target allocation to fixed income (which depends on the preferences and circumstances of the investors involved), should we hold inflation-indexed or conventional government bonds?
(The general trend is to overweight bonds that incorporate credit or prepayment risk, which makes the allocation decision slightly more complicated. Indeed, there are no significant sources of credit-indexed bonds private sector inflation. This means that while we believe inflation-indexed bonds (also known as “linkers”) will slightly outperform conventional government bonds, “spread products” could still outperform them. .To make life easier, I’m just talking about the credit risk-free investing space.)
(I assume the reader knows the definition of a breakeven inflation rate. To quickly recap, it is the future average inflation rate that results in an inflation-indexed bond and a conventional bond of the same maturity having the same total yield. until maturity. If this information is not enough, it is explained in this introduction on my blogand at greater length in my rather amazing book on the inflation-linked market.)
If we look at the figure at the top of the article, we see that the 10-year breakeven point (top panel) has stabilized in a trading range after some enthusiasm around the pandemic. The 5-year breakeven point, 5 years ahead – which isolates the breakeven point from expected near-term inflation from energy markets – stabilized in a similar range even earlier.
If we are doing relative value trading with leverage, there were definitely opportunities to make or lose money trading links. However, from a strategic perspective, we are interested in significant outperformance/underperformance of the overall asset class relative to conventional bonds, and we need many carry or breakeven moves for this to happen. happen. From a long-term investor’s perspective, this is not a disaster, as you may want to partially hedge against large movements in expected inflation. (Note that this coverage has limits.) You probably want to allocate your risk budget elsewhere – and you might have gotten better returns.
One possible interpretation of this phenomenon is that central bankers are doing an excellent job of anchoring inflation. Yay! Another theory is that modern economies have much greater inflationary inertia than they did in the heyday of the welfare state and old Keynesian management of the business cycle. Another theory is that the bond market is broken and/or bond investors are wrong.
Anyone familiar with modern quantitative research will begin to wonder about risk premiums embedded in breakeven inflation. My bias is that outside of a crisis, bond bonds tend to be slightly expensive relative to their fair value, since the ultimate source of inflation protection is solely the bond bond offering of the central government. (Other issues are invariably traded by someone, and the inflation swap market in turn relies on government ties for inflation protection. All investors with large balance sheets are already short of inflation risks, and no sane counterparty will accept large amounts of directional inflation risk from quick money accounts with weak balance sheets.) The beauty of my theory is that it is largely unfalsifiable in the absence of another century of data, so I won’t worry about alternative theories here.
This theory tells us that bond investors expect the next decade to likely resemble most of the post-1990 experience and hold around 2% or so. In other words, mood swings about inflation among economic commentators have had virtually no impact on breakeven inflation.
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