Delegate biographies: Learn more about the panelists
Executive summary
• The inflation-linked market is growing in size and importance
• Reports of the death of inflation have been exaggerated
• New markets are opening up
• As in other markets, the credit crunch has had an impact
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PW, Western Asset There is about $1.3 trillion of bonds in the inflation-linked markets, so it’s very important. As inflation caused uncertainty and concern, 2007 was important for the inflation-linked market. US TIPS performed very strongly. What happened there?
DD, Axa This time last year there was a feeling that perhaps inflation was dead but since then we’ve seen a turnaround. The first half of the year saw increases in food, fuel and energy prices. Then the credit crisis came through in the second half and the central banks’ response has led to fears that they are going soft on inflation. Will the slowdown in the economy lead to a fall in inflation or will the policy easing from the Federal Reserve lead to an increase? We’ve got a genuine debate, which can only be good for inflation-linked markets.
JG, Standard Life The dichotomy is the difference between genuine inflation expectations, and inflation expectation as expressed by break-even in the market. Despite the inflation pick-up over the past year, TIPS break-evens have barely rallied. There’s every reason to believe that the Fed will continue to cut rates aggressively. Yield curves have steepened, but break-evens haven’t adjusted. It’s a mystery but potentially it’s also a huge opportunity.
CA, RBS The break-evens are trading in a way that doesn’t support the data, other than at the short end where the shorter-dated TIPS follow the pattern of oil price news. All year, we’ve viewed longer-dated break-evens as an opportunity, not always with success. Having said that, we still consider TIPS to be attractive.
MR, Dresdner Kleinwort Most people believe oil prices are high but might come down sharply. That’s why only the short term of the break-even curve went up, whereas the medium and long part haven’t moved much. Year-on-year inflation will slow down during the course of the year, so that could be why they haven’t rallied.
GFP, Eurizon Capital The oil price increase pushed innovators to develop new alternative energy technologies and such a phenomenon is one more factor that allows people to believe that in the long run we shouldn’t have a structural shift in inflation.
JG, Standard Life This move in energy prices is different from previous rallies because it’s not just the front contracts. It’s happening across all contracts. There is a perception that this is a longer-term squeeze on energy prices, which will be longer-term inflationary. It’s not a return to the bad old days, but risk has gone up.
PW, Western Asset Break-evens include a risk premium that we can’t measure. But we can guess, so we know that the majority of break-even is the market’s expectations for inflation. It’s supposed to give us the signal that inflation’s under control and policy-makers are doing a good job. The US performed well because interest rates were either held stationary or cut aggressively, or were expected to be cut. In Europe, interest rates rose and there is a more pragmatic attitude from the European Central Bank. Consequently, European markets did poorly. Do you think that’s a signal that inflation expectations in the bond market and the TIPS market are not representative of true inflation expectations in the community?
GFP, Eurizon Capital There could be some demand and supply imbalances in the market that can render the signal less representative of the actual inflation expectations. That is quite evident in the UK, where the hedging needs of inflation-linked liability accounts generate an excess of inflation demand. Maybe we could make a cross-sectional check on a sample of different countries in order to measure the bias generated by such hedging needs. There should be a relationship. Furthermore, because of the still relatively underdeveloped inflation asset swap market, especially in local inflation indices, with low levels of basis trading activity, you can have another source of bias.
PW, Western Asset Were you surprised by the UK inflation market?
DD, Axa In theory, the UK should be the easiest market to forecast, because of the Bank of England’s explicit inflation target. But the UK illustrates that there can be different supply and demand factors affecting the nominal and the inflation market. They can each be traded independently, and that will affect the level of break-even rates. There was more demand in the UK last year for short-dated conventional bonds, and that has distorted the break-even rates at the shorter end as in previous years liability driven investment purchases have boosted break-even rates at the longer end.
PW, Western Asset Perhaps those following the UK wouldn’t have been surprised by it being so strong, and in a period where inflation was high. What about other markets?
CA, RBS Sweden is coming to the fore. People are starting to consider derivatives and the government is reining in issuance, in nominal and index-linked. At its peak, the 30-year Sweden swap was 35 basis points over the 30-year euro equivalent swap. We’ve had a couple of strong prints in Sweden, but if you look historically at where it has printed relative to the euro, there are not many examples of Sweden being through Europe, yet their swap’s up at 35bp. If the market developed you’d see that moving further still.
PW, Western Asset So could Sweden be one of the star performers?
CA, RBS Activity has increased. But they’re still small markets. The development of lesser non-core indices was one of the themes of last year. But sterling supply and demand was interesting. Towards the end of 2006 there was a lot of corporate issuance and negative basis trading providing swap supply. For the first time since 2000 we saw long-dated inflation swaps trading through bond break-evens. That sustained itself for the first quarter of 2007, following pre-emptive over-issuance in 2006 while conditions were so favourable. When that pressure was taken off, not only did the bond swap go back to being with swaps in excess of bond break-evens, but we’d spent three years with the benchmark 30-year inflation swap stuck in the 300 to 320 range. Once we got through that, 350 was the next stop.
