Why inflation is now overpriced by the UK bond market
2nd November 2016
UK inflation is topic du jour. Market-implied levels of inflation have skyrocketed, while stories from Marmite price rises at Tesco to Apple product price hikes have made front page news. Investors are worried, and the recent rise in UK market-implied inflation has likely been one of the drivers of gilt underperformance in October’s global bond sell-off.
Before the important Bank of England Quarterly Inflation Report is released tomorrow, we wanted to take a closer look at the issue.
Like in much of the developed world, inflation in the UK has been trending lower over recent years, primarily due to global forces, although the strength of sterling up to 2014 also played a part. Although it has risen recently, the latest inflation reading showed consumer prices (headline Consumer Price Index (CPI)) rising by 1% over the year to end September, while core inflation (a measure that excludes volatile food and energy prices) was measured at 1.5%. The Bank of England has a target of 2.0% for headline inflation.
Break-even inflation rates and inflation swaps are the primary sources of market-implied inflation rates. Both of these use Retail Price Index (“RPI”) inflation as the index; the difference between RPI and CPI (known as ‘the wedge’) is around 1%, which is where we expect it to stay in the future. When we refer to a 10-year inflation rate, we are talking about average inflation over that time (not precisely true, but close enough for this analysis). For further details see the “Inflation Market Notes” section at the bottom.
Here is what market prices currently imply for UK inflation:
Inflation is therefore priced to rise in the near term, which makes sense, given the recent fall in sterling. But perhaps surprisingly, the market is now also pricing for that high inflation to persist over the long term. Essentially, the market is saying that UK inflation could be 0.5% above the Bank of England target forever.
Some are suggesting that global deflationary pressures are over. There has been increasing focus on the fact that China producer prices are now increasing, having been in severe deflation since 2012 (e.g. see here). However, while factory gate prices are indeed now rising in local currency terms, it is essential to consider that China has devalued its currency by 7% on a trade-weighted basis in the last 12 months, meaning therefore that China is exporting more deflationary pressures than when Producer Price Index (PPI) was falling 6% year on year in 2015.
Meanwhile, long-term structural deflationary pressures stemming from demographics, technological change and globalisation remain broadly intact. We have not – yet – seen any evidence to change our view on these drivers.
At the UK level, it’s worth highlighting that various measures of wage growth are stable at around 2%, which is far from indicating an overheating labour market. Further, if UK economic data weakens next year and in the years following as the Bank of England has previously suggested (we’ll find out more tomorrow), then there is a possibility that labour market slack could increase from here, not decrease.
We think the recent move in implied UK inflation is overdone. Consider the following:
- The pass-through from weaker Sterling to inflation is limited
- We estimate (similarly to the Bank of England (BoE)) that a sustained, 10% fall in trade-weighted sterling amounts to a rise of around 1.2% in headline inflation, in the first year. Most of the effect occurs in year 1, with smaller effects in the next two years
- Now of course, we have not yet seen much of the pass-through, and indeed, the most recent inflation number does not include the further 5% fall in GBP experienced in October
- On the 15% fall in trade-weighted GBP then this year, a back of the envelope calculation sees CPI peaking at around 2.5-3.0%.However, it is too easy to simply take the difference between the highest value of GBP in the last year, versus today’s value. As mentioned, the currency → inflation effect is lagged, and so we need to look at sterling over a longer time frame.The chart shows GBP against the Euro, which forms the bulk of the UK’s trade-weighted basket. GBP has clearly weakened this year, but has only returned to pre-2014 levels.
Hence, CPI may actually peak at the low end of our estimate in the first half of 2017. After that, base effects mean that CPI should slowly fall – after all, inflation is a year-on-year number.
- Weaker UK growth
- If we assume that some of the fall in GBP is due to the potential negative effects on UK growth, then that lower growth should be negative for inflation, primarily via the labour market as mentioned above.
- Technical outlook
- UK Inflation-Linked bonds (and RPI swaps) have massively outperformed conventional bonds since the Brexit referendum
- Notably, since July, there has been only a tiny amount of linker supply – that is about to change. Q4 supply in inflation-linked is going to be large, with upcoming long-end syndication in November. Linkers tend to perform very poorly ahead of these syndications
- Breakevens should weaken considerably on this alone.
- Potential for stability in GBP
- We think the political situation has stabilised in the UK, at least for now. May’s government is showing that it can be flexible to concerns about a hard Brexit. We think that the Pound can stabilise or even go a little higher from here, at least in the near term.
- Oil Prices
- Inflation expectations have risen in much of the developed world, driven by higher oil prices. I believe the market, as always, has too much of an upward bias regarding oil prices, and too much faith in a potential OPEC deal. The market is oversupplied, US shale producers can increase production very quickly, and OPEC countries who are themselves economically stretched are reluctant to take short-term hits to both revenues and market share
- Oil prices have fallen over 10% from the mid-October highs, but this has surprisingly not yet been reflected in market-implied inflation rates.
Where mandates allow, we have therefore expressed the view that UK market-implied inflation rates are likely to fall, and have done this via UK 10-year RPI swaps ahead of the quarterly inflation report. Mark Carney and the BoE have erred on the dovish side pre and particularly post the Brexit referendum, and we expect them to talk down any medium-term inflation hysteria. In particular, we expect the BoE to talk up the downside risks to growth, while acknowledging of course that recent UK economic data has been stronger than previously expected.
Inflation Market notes
Breakeven inflation is simply the yield on a conventional UK government bond minus the real yield on an inflation-indexed government bond on the same maturity. The breakeven inflation rate is therefore the inflation rate that makes an investor indifferent between owning the inflation-linked bond or conventional government bond.
Inflation swaps are derivative instruments which swap coupons based on RPI Inflation for fixed payments. By design, then, these provide an estimate of market-implied inflation.
Both of these instruments should show roughly the same rate, although inflation swaps are usually higher due to technical distortions (e.g. pension fund demand). However, they certainly move in tandem. For our analysis above, we use inflation swap prices, and adjust by 1% to get market-implied rates of headline CPI.
* Dove refers to an economic policy advisor who promotes monetary policies that involve low interest rates, based on the belief that low interest rates increase employment. – Investopedia, accessed on 08.11.2016
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