Central bankers are preparing bond markets for inflation overshoots

22nd November 2016

Ben Lord, Manager of the M&G UK Inflation Linked Corporate Bond Fund, comments on the outlook for inflation and impact on markets.

“The market has quite rightly seen inflation coming. In the first quarter of 2017, barring some unforeseen shock in oil, US and UK CPI indices will be back above 2%. Perhaps meaningfully so, depending on where oil is at that stage. In the UK, the story is then augmented by the fact that our currency, on a trade-weighted basis, is 20% lower than it was at its peak in the middle of 2015. This means that, according to the Bank of England’s own projections, we should expect to have 4% to 6% higher CPI outcomes over the next 2 years. So, 2% to 3% higher inflation than now in 2017 and 2018, give or take.

“UK bond markets presently are priced for RPI to average 3% a year for the next 5 and 10 years. This implies, very broad-brushed, CPI to be around 2% on average for the next 10years, so the Bank of England is going to approximately deliver on its inflation targeting mandate.

“Now, the UK economy has full access to the single market for the next 2.5 years, and after that we have no idea what happens next. If I was running a company making widgets, for example, exporting to UK and European customers, I would be making sure that I operate at full capacity for the next 2.5 years. I would be hiring and investing ahead of the uncertainty event. I am bullish on the UK economy, and we now have lower interest rates and more liquidity after Mark Carney’s stimulus package than before. And yet nothing changes for 2.5 years. So the only view I can have on the UK economy at this point is that the outlook for demand is solid for the next two and a half years.

“In the bond markets we have all been looking towards healthy labour markets driving wages up, which in turn should drive up inflation. This has not materialised, and to many of us, this remains the last remaining puzzle of this recovery’s cycle. Perhaps, though, we have been looking in the wrong direction? Perhaps it is much more likely, and intuitively it makes some sense, that inflation will lead wages. We will be watching wages very closely in 2017 for evidence of this.

“Prices that companies pay for their input costs (PPI input costs) are now rising at a 12.2% higher rate than this time last year. Hedges have expired, and the pass-through to consumer prices is a matter of when, not if.

“Central bankers are also preparing bond markets for inflation overshoots. And Janet Yellen’s Fed have stated that their tolerance for inflation overshoots and undershoots is symmetric. In simple terms, the Fed has undershot its 2% inflation target by almost 1% per year for the last four years. Now we learn that their inflation targeting policy would tolerate an overshoot of 1% per year for each of the next four years. That’s a big deal. Indeed, on the other side of the world we recently learned that the Bank of Japan’s new inflation target is to overshoot their inflation target. Who knows whether recent rises in inflation expectations are genuine and long-term, or whether they are a short term false dawn. But central bankers are already preparing us for higher than target inflation.

“Finally, bond breakevens, the fixed income market’s expectations for inflation, should surely be higher in the short term and lower in the long term, if the bond market’s view is that this inflation is import-driven, and transient. And yet breakevens are telling us the opposite: 5 year and 10 year breakevens are 0.5% lower each year than 20 year and 30 year inflation expectations. The bond market is priced for this inflation to be more than short term, and to be above target for at least the next 30 years.

“I think we are at the early stages of a pricing out of deflation risk. We will not have to wait long to find out what the next phase in this inflation cycle is.”

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