Analysis-UK linker frenzy sends investors overseas for inflation hedge


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By Abhinav Ramnarayan and Tommy Wilkes

LONDON (Reuters) – Britain appears to be a place where investors urgently need an inflation hedge, but many say trading in domestic bonds designed with this in mind is so overstating the pressure on prices it ‘they have become too expensive to consider.

Inflation-linked government bonds are preferred when prices go up because their principal and interest payments go up and down as prices change.

Interest in them in Britain – including from what one securities trader has dubbed “the inflation tourists” – has skyrocketed as labor and labor shortages. goods fueled inflation fears.

Even in normal times, UK linkers enjoy huge demand from local pension funds, especially defined benefit plans which promise to account for inflation when paying. This lowers yields and increases breakevens – the implied inflation rate.

They pay a return linked to the Retail Price Index (RPI) rather than the Consumer Price Index used by the Bank of England. Because the RPI tends to be 0.8% to 1% above the CPI, inflation expectations should be lowered accordingly.

But even after factoring in this gap, fund managers say they are forced to seek the same protection overseas as the UK market as investors positioned for lower inflation have also already been squeezed out. more and more fundamentals.

One-year indexed gilts currently imply an inflation rate of 5.8% while five-year linkers show it at 4%.

The BoE expects consumer price inflation to briefly exceed 4% by the end of 2021, then decline.

The poor value for money in the linker market is especially true, according to investors, given the recent aggressive review of the BoE’s tighter policy in the UK government bond market.

UK two-year yields have risen 42 basis points over the past month and a half, while US two-year yields are 14 basis points higher and Germany only 5 basis points higher.

DEMAND / SUPPLY IMBALANCE

“It’s too rich a bonus for us. There are cheaper options, ”said John Taylor, co-head of European bonds at AllianceBernstein.

As inflation expectations rose, Taylor sold UK government bonds, adding exposure to inflation-linked bonds in Australia and the US where prices don’t seem that out of step.

UK 2-year inflation swaps forecast an inflation rate of 4%, double the BoE’s target and up from around 3.83% in early September.

The US and Eurozone equivalents at 2.77% and 1.78% have moved even further, but both remain much closer to their central banks’ inflation targets.

Royal London Asset Management Head of Alpha Strategies Paul Rayner has also ditched UK linkers in favor of Australian, US and Eurozone inflation-linked bonds, as well as Japanese, where breakevens are close to zero.

These offer better ways to position themselves against rising UK and global inflation, Rayner said, calling UK linkers “extremely overvalued”.

Part of the increase in breakeven point, according to an inflationary securities dealer at a major bank, is due to “inflation tourists” – investors who are usually not involved in the market but suddenly want protection .

This has exacerbated the imbalance between supply and demand in a market where some 1.7 trillion pounds ($ 2.3 trillion) of primarily inflation-linked pension fund liabilities pursue products of a worth less than 500 billion pounds.

“This type of camp adds pressure for breakevens to rise and that usually means headline inflation will start to peak and then reverse,” the trader added.

Assets held in European-domiciled sterling inflation-linked bond funds – a proxy for the broader linker market – reached € 16.9 billion in August, just short of the previous month’s record. according to Morningstar data.

In the first eight months of 2021, they received € 876 million in net cash, the biggest gain since 2017.

Chart: UK breakeven inflation skyrockets https://fingfx.thomsonreuters.com/gfx/mkt/myvmngoxypr/breakeven%20inflation%20oct%2012.png

INFLATED EXPECTATIONS

Fahad Kamal, chief investment officer at Kleinwort Hambros, said inflation expectations had been “massively higher than what actually happened” for years. The slowing growth and demographics “are far more important forces than the short-term supply problems which are exciting the markets.”

“This is probably an overestimate of inflation by a few percentage points, based on historical averages,” said Kamal, who turned to US stocks for “a much better indicator of inflationary pressures. global “.

Others, including Savvas Savouri, chief economist at Toscafund Asset Management, say the CPI basket itself needs to be revised because it does not take into account the deflationary impact of technology.

While linkers imply a 3.2% CPI in five years, he expects actual readings to be 2% to 2.5%.

($ 1 = 0.7355 pounds)

(Supplementary report by Sujata Rao and Dhara Ranasinghe; edited by Sujata Rao and John Stonestreet)

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