LONDON, Aug 10 (Reuters) - 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
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, wheat and copper 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
If that played out, could it call time on the scramble for
inflation-protected bonds that's defined much of the
Mutual fund data captured by Bank of America shows four
consecutive weeks of outflows from these so-called 'linker'
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
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
"Market pricing of inflation is not in line with our views,
so (there are) opportunities in inflation-linked bonds."
The author is editor-at-large for finance and markets at Reuters
News. Any views expressed here are his own
(by Mike Dolan, Twitter: @reutersMikeD; Editing by Emelia