An Uneasy Truce

A glance at the performance of leading inflation-linked bond ETFs since the end of last summer demonstrates how investors simply can’t make their minds up about one key question: Are we facing inflation or deflation?

The chart shows all four iShares Dublin-based inflation-linked bond ETFs, covering global, sterling, US dollar (TIPS) and euro issues.  Fund NAVs have been taken from the iShares website and rebased to 100 at 1 August 2008 (the date on which the global inflation-linked ETF was launched).

The price trends of all four funds over the last 11 months are similar in shape, if not in scale.  The period from August to November last year witnessed the collapse of Lehman Brothers and the near-failure of AIG.  This led to concerns about falling prices (deflation), which reached their peak in November/December.  As inflation-linked bonds would suffer an erosion of both capital and interest income under deflationary conditions, it’s unsurprising that there was heavy selling of this asset class during the period.

When I wrote about this ETF sector in December last year on, I noted that the break-even inflation rate between inflation-linked and fixed-rate government bonds (the future inflation rate at which you’ll get an equal return from both) had moved into negative territory in the US, UK and Japan.  In other words, a period of deflation had already been discounted in these three countries (nearly -3% for four and three years in the US and UK, respectively, and -2% for ten years in Japan).  

These negative inflation expectations were the result of two factors: the decline in the yields of conventional government bonds at the end of last year as investors rushed to buy them, and the rise in inflation-linked yields.  If actual inflation turned out to be higher than the level implied by break-even rates, investors would do much better in inflation-linked bonds than in conventional (fixed-rate) ones.

Since the beginning of 2009, things have changed dramatically.  Investors have returned to inflation-linked bonds and their price has risen steadily, as the chart shows.  At the same time, conventional government bonds have performed very poorly, with US Treasuries, for example, on course for their worst performance since 1978.

The net result of these two price trends is that break-even rates between inflation-linked and fixed-rate government bonds in the major markets have moved back into positive territory.

In the UK, the break-even inflation rate is now 1% over two years, 2% over seven years and 3.6% over thirty years (using the retail prices index as the measure of inflation in the UK).  In the US, the break-even rate is 0.6% over three years and 2.15% over twenty years.  In Sweden, France and Canada, break-even rates are also in the 1-2% range for the next ten years.  Japan remains the exception – according to the Ministry of Finance’s quarterly newsletter, the ten-year break-even rate is stuck in negative territory, at around -1.5%.

It seems to me that these discounted inflation rates – very low single figures for the foreseeable future – cannot be right, and are the product of an uneasy standoff between the deflationist and inflationist camps.

There are two obvious ways to recover from the huge debt burden left in the aftermath of the credit bubble.  One is to have several years of high – possibly double-digit – inflation to reduce the real burden of the debt.   The other is the deflationary route, with falling prices, widespread defaults and eventual relief through debts being written off.

It’s a binary outcome, and either route would mean that inflation-linked bonds are mispriced.  Which way we go, however, is anyone’s guess.  I’m more convinced by the arguments of the deflationist camp, but I wouldn’t stake a lot on it.  And judging by investors’ schizophrenic behaviour over the last year, there seem to be a lot of us in the same boat.

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