What is the impact of QE and ultra-low monetary policy on inflation-linked bonds?
As the world was expecting to see a return to higher interest rates and an eventual end to quantitative easing (QE) across several economies only two years ago, it is finding itself in an environment of even lower rates and larger QE packages in 2020.
With the current market and social environment going through an exceptional phase, the time is right to re-evaluate what this might mean for investments such as inflation-linked bonds. While the impact on economies across the globe is difficult to pin down, comparing the environment to the most recent events of recession, low interest rates and QE, could give an indication for the asset class.
During the recent years of QE, inflation-linked bonds have performed well, which lets us believe that inflation-linked bonds should also be well supported this time. This is partly due to the fact that, in times of uncertainty, investors look for defensive assets. As inflation-linked bonds are mostly issued by sovereigns, especially highly-rated ones, the bonds fall into that category.
The bonds provide a good level of comfort to investors on the issuers’ solvency. On top of that, most inflation-linked bonds are included in central banks’ QE packages, which offer additional liquidity support to the asset class.
Real interest rates at attractive levels
Inflation-linked bonds have recently been sold by investors focusing on the short term, with the aim of liquidating assets in order to address margin calls or to free up some cash. This, as well as a reduction in inflation levels, resulted in an increase in real interest rates, which in our view is an opportunity.
Historically, one of the main effects of QE programmes has been to push real yields lower, supporting inflation-linked bonds’ valuations. The graph below shows the relationship between the balance sheet of the US Federal Reserve and government bond yields.
Figure 1 - Source: Refinitiv Datastream, data as of 10 June 2020
Inflation expectations have weakened
Inflation expectations are depressed as a result of the drop in oil prices and expectations of much slower economic growth going forward. When considering inflation-linked bonds as an investment, inflation expectations are key to working out value. In the year ahead, the markets are pricing in deeply negative inflation expectations (see figure 2), due to this year’s crash in oil prices. Still, oil price futures are suggesting that a sharp rebound is ahead of us (see figure 3).
Figure 2 – Source: Bloomberg, data as of 29 May 2020.
Figure 3 – Source: Bloomberg, data as of 29 May 2020.
While it is reasonable to expect inflation to be close to 0% in 2020, the combined impact on inflation of the largest QE measures ever globally coordinated and the biggest budget stimulus measures remains to be seen. The economic recovery that will eventually follow, may see some significant inflationary pressures as was the case after the ‘Great Recession’ of 2008 or after the Fukushima nuclear disaster in 2011.
Figure 4 - Source: Bloomberg, data as of 29 May 2020.
Ultra-low interest rates can also be beneficial to inflation-linked bonds, as this offers the bonds room to outperform. While in general fiscal stimulus could counteract this, and push interest rates higher, these extraordinary times seem to warrant the extraordinary fiscal measures. We do not see a risk of an imminent spike in interest rates on the back of the fiscal support packages.
What is even more, with inflation expected around zero for 2020, the question arises if, in fact, we are at risk of deflation.
A risk of deflation?
During the banking and sovereign debt crisis some 10 years ago, countries like Japan and the Euro Area, indeed, had to fight disinflationary forces. In the Euro Area in particular, the response to the sovereign debt crisis was lower fiscal spending, which culminated in large austerity packages. These measures proved to be suboptimal in supporting the recovery, which led to years of recession and disinflation.
Today’s measures significantly differ from 10 years ago: The enormous fiscal impulses governments are willing to commit to, to sustain the economy in the aftermath of the COVID-19 outbreak, should ultimately have a positive effect on growth and this will ultimately also translate into an uptick in inflation. We do not believe that deflation is a material medium-term risk.
In any case, markets have to price in higher inflation to a certain extent, as, in our opinion, current market levels look too depressed.