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Inflation products: The best bet in town?

Inflation is back, and so are inflation markets after a three-year hiatus brought on by the financial crisis. With some central banks happy to let their economies reflate to foster employment and a sustained recovery, inflation-linked debt might be the best bet in town. Hamish Risk reports.

IN MANY RESPECTS the beginning of 2011 seems very much like early 2008: a time of surging food and commodity prices that go on to spur food riots and social instability in the developing world. They are also stirring a realization that the changing face of globalization might be bringing down the curtain on more than two and a half decades of benign inflation.

Back in early 2008, before the great deleveraging of the financial system had gathered any real momentum, break-even inflation trading, the gap between nominal bond yields and inflation-linked bond yields, was in full flow. As oil prices peaked at around $147 a barrel in July 2008 and rice prices reached an all-time high, inflation became the bet du jour of the fixed-income markets. Those bets ran into a brick wall later that year, as Lehman Brothers went down the tubes.

"From about mid-2008 there was a disproportionate percentage of investors that were taking inflation views, via break-even positions" recalls Alan James, head of inflation-linked research at Barclays Capital. "The vast majority of them got stopped out in a vicious deleveraging between September and November 2008. Every break-even investor was taken out, and subsequently there was very little break-even trading for two whole years."

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