After months of angst about deflation that has led many central banks to adopt negative interest rates, there’s been a sudden burst of speculation that inflation may be back.
In the United States and Britain at least, many investors are betting that inflation has reached its nadir and are seeking to insulate their portfolios against rising consumer prices.
Demand for US Treasury inflation-protected securities (TIPS) is at its strongest in years, while benchmark TIPS exchange-traded funds have recently chalked up their best quarterly performance in 12 years.
TIPS purchases are being recommended by giant asset managers BlackRock and Pimco and banks such as Morgan Stanley, while economists at Citi say the ‘lowflation’ that has defined the US and British economies in recent years seems to be ending.
“Even if core inflation stays where it is, buying a TIP will return 70 basis points more than buying a nominal Treasury bond,” said Shyam Rajan, head of US rates strategy research at Bank of America Merrill Lynch in New York.
“Valuations are very attractive. Breakevens are still cheap by any metric,” he said.
The yield premium on regular US Treasuries is currently 1.75 per cent and the yield on TIPS is 0.15 per cent, giving a breakeven rate of 160 basis points. With US core inflation now running at 2.3 per cent, a four-year high, investors can pick up a real return of 70 basis points.
Investors are flocking to TIPS products. According to BAML, investors have been net buyers of TIPS funds for seven straight weeks, the longest run in almost a year. Cumulative inflows into these funds now stand at $4.8 billion, also the highest for nearly a year.
Moves this year in the benchmark TIP exchange-traded fund tell a similar story. The $16.5 billion ETF rose 4.4 per cent in the first quarter of the year, its best quarterly performance since the same three-month period in 2004.
“Given the downside support from the Fed and the relatively low level of breakevens, we think investors should continue to maintain long positions in 30-year TIPS and in breakevens,” Morgan Stanley told clients.
The US five-year, five-year forward rate used to measure inflation expectations rose as high as 1.75 per cent late last week compared with post-crisis lows of 1.42 per cent in February.
The big question is whether the picture in the United States, and to a lesser extent Britain, is exceptional or whether it is a bellwether of global inflation trends.
In Europe and Japan, inflation remains near zero and any significant rise appears a distant prospect as cheap oil, the slowdown in China and other emerging economies, and the US dollar’s rise of over 20 per cent in just four years weigh.
More than $6 trillion of European and Japanese sovereign bonds currently trade at negative yields, suggesting investors remain sceptical that years of extraordinary monetary stimuli from central banks will reignite consumer price inflation.
German 10-year nominal bond yields shrank below 0.10 per cent for the first time in a year this week, and economists talk of negative central bank deposit rates persisting for years.
Eurozone five-year inflation swaps are falling back toward February’s record low of 1.36 per cent, while even the University of Michigan’s five-year US inflation outlook index is hovering around its lowest ever, comfortably below three per cent.
Jamie Searle, rates strategist at Citi in London, says there may be signs that European demand for inflation protection is slowly beginning to pick up, particularly from investors looking to hedge longer-term inflation risk.
“There’s a growing sense that the bounce in US TIPS has helped create a more positive backdrop. It’s quite tentative though – we’re not talking about a broad-based pick up in global inflation here,” he said.
So much now hinges on the oil price.
After rallying more than 50 per cent from lows earlier this year, world crude is struggling to get a foothold above $40 a barrel. The persistent supply glut and ebbing global demand suggests $30/barrel could be revisited as easily as $50, especially if no meaningful deal to limit production is struck.
But some think the rollback in US shale oil output that is already underway, itself a response to the oil price collapse, may be enough to create a price floor.
“While there are near-term downside risks to prices as the market continues to rebalance, the medium-term forwards may actually under-price how we expect fundamentals in the energy market to evolve,” Goldman Sachs strategists Francesco Garzarelli and Rohan Khanna wrote in a research note on Tuesday.