We see a potential for higher inflation breakevens and find value in short duration inflation-linked bonds
- Central banks are returning to monetary easing, inflation-linked bonds have room to catch-up
- Inflation expectations are depressed despite inflation forecasts remaining stable - this is a value opportunity in our opinion, we see room for higher inflation breakevens
- Short-term inflation-linked bonds are globally attractive thanks to the potential for lower real yields and cheap inflation breakevens
Central banks are returning to monetary easing, this is an opportunity for short-term inflation-linked bonds
Short-term inflation-linked bonds have room to catch-up with the broader fixed income rally. Money market expectations point to more accommodative market conditions while inflation-linked bonds real yields have been lagging as inflation expectations have reached rock-bottom.
We believe that over the coming 6 to 12 months short term real yields could fall by 0.5% netting a gross return of up to 1.5% hedged back into EUR1 (up to 3.8% hedged back into USD2) over the period (using the International Monetary Fund’s inflation forecasts as an input and market prices as at end of September).
Inflation breakevens trading below the level of inflation is an opportunity to enhance portfolios income
The economic slowdown has pushed market based inflation expectations to a depressed level. According to our analysis the market is now as pessimistic as back in 2016 before the US election.
In the current environment, inflation breakevens are trading below the level of inflation that is expected for next year, meaning that investors buying inflation-linked bonds should enjoy a higher income than in similar maturity fixed-rate bonds issued by the same issuer. As an example, 5-year US inflation breakeven (the inflation expectation that is embedded in the price of inflation-linked bonds) is trading close to 1% lower than the year ahead forecasts of inflation from the consensus of economists, creating an advantageous yield pick-up opportunity in our opinion.
We see room for higher inflation breakevens given current pessimistic pricing
Finally, we believe that the combined effect of the trade war and Brexit have been weighting on inflation breakevens since the beginning of the year.
The change of tone of central banks combined to historically attractive valuations lead us to believe that inflation breakevens should normalise in the coming months as investors come back to the asset class. A resolution on the trade war or Brexit front would only make this call stronger.
1. We forecasts a EUR-currency-hedged income of 0.05% over the coming year using the International Monetary Fund’s inflation forecasts and current market prices at the end of September as inputs. As we expect real yields to decrease by potentially as much as 0.5% with 3-Years of duration this could equate to as much as 1.55% of gross performance.
2. Using current market pricing of EUR-USD currency hedging costs as at end of September
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