Markets expect decades of inflation frustration

It might seem extraordinary that the developed world could fail to generate enough growth to lift inflation back to target for decades, yet there is mounting evidence this is a real possibility.

The steady slide in market gauges for long-term inflation in the US, Europe and Japan has accelerated since Britain’s vote to leave the EU last month, which dealt a fresh blow to a stuttering global economy.

The last century has been punctuated by pockets of low or declining consumer prices, but even those warning of the depressing effects on inflation of shifts like slowing birth rates may be underestimating what awaits if markets are right.
This will have profound implications for wages, spending and levels of debt across the developed world.

Some investors warn these market bellwethers — closely watched by central bankers hoping their vast stimulus injections will prove effective — are way off the mark. However, few appear to be trying to profit from this supposed mispricing in inflation-protected bonds.

“What the inflation market is currently pricing is an incredibly benign inflation trajectory in the next 10 to 20 years,” said Martin Hegarty, head of inflation-linked bond portfolio at BlackRock in New York.

“We are pricing a run rate that implies the Fed will miss its inflation target for a very, very long time and not only a miss but miss by a very wide margin.”

The so-called “breakeven rate” — the difference between the yield on an inflation-protected and a nominal bond of the same maturity — is viewed as a proxy for market inflation expectations.

Breakeven rates in the world’s largest economy, the US, are currently 1.49 percent for 10-year debt and 1.63 percent for 30-year bonds. This shows investors believe the Federal Reserve will miss its 2 percent inflation target over the next three decades.

Central banks in the euro zone and Japan face an even bigger challenge in getting consumer price growth back to their 2 percent targets, market pricing suggests.

German 10-year and 30-year breakeven rates, the euro zone benchmarks, stand at 0.78 percent and 1.1 percent respectively, while Japan’s 10-year rate is just 0.28 percent.

Even financial derivatives designed to strip out near-term volatility — five-year, five-year forward inflation rates which measure where 2026 inflation expectations will be in 2021 — paint an ominous picture in the euro zone and Japan.

“Market measures of inflation are starting to reflect this idea of global secular stagnation — that the money central banks are spending will struggle to harness animal spirits and drive up inflation,” said Mizuho International’s head of euro rates strategy, Peter Chatwell.

One outlier is the United Kingdom, where markets expect inflation to overshoot as the country goes through painful devaluation of its currency post-Brexit.

It is hard to measure the historical accuracy of these longer-term market measures against survey-based forecasts, which tend not to venture as far into the future.

But analysis by Mizuho shows that when it comes to predicting euro zone inflation a year in advance, market inflation swap rates have shown a statistically relevant degree of accuracy since 2010, while the ECB’s survey of professional forecasters has not.

Yet within the central banking community, distrust of these market gauges is growing.

Minutes of the ECB’s June meeting released last week showed policymakers expressed doubts about relying too much on market-based measures of inflation expectations, which had deviated strongly from survey-based measures.

And if these measures are distorted, it may well be a result of the very policy that aims to lift inflation.

The New York Federal Reserve has argued that excessive foreign demand for longer-dated US nominal bonds — created by a hunt for returns in a world where central bank money has sent asset prices skyrocketing — has crushed yields so far that they are artificially suppressing forward breakeven rates.

“People in the markets are clearly concerned that inflation will remain low for a very long period of time, but we think some of these measures have overshot a bit to the downside,” said Michiel de Bruin, head of global rates at BMO Global Asset Management.

“In a flight-to-quality market when there are concerns about growth and matters like Brexit, the knee-jerk reaction is to buy the most liquid nominal bonds and that is likely playing a role.”

MODEST FLOWS

Yet if investors thought inflation-linked bonds were underpricing the future path of consumer price growth, a rush of buyers should be expected to purchase inflation protection below its expected value.

According to ING fund data, that has not been the case, implying investors either have little conviction about future inflation or are worried about a further decline.

In the first week of July, inflows into inflation-linked bond funds were modest, equating to a 0.3 percent build in North American assets under management and a 0.1 percent rise in Western Europe funds.

Over the past month, inflows were 1.3 percent in North America, while Western Europe saw outflows of 1.4 percent.
Demand for inflation-linked bonds in Japan is so tepid that the ministry of finance was forced to reduce the amount it planned to issue earlier this year.

source: Reuters