Inflation-linked bonds – waiting for a catalyst for higher breakevens

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After an eventful May for bond markets, Cedric Scholtes, Co-Head Inflation and Rates Committee Chair at BNP Paribas Asset Management, gives his views on US breakeven inflation (BEI) rates, risks from Italian political uncertainty and deepening trade tensions, and the implications of the June FOMC meeting.

Cedric, how have you navigated recent developments?

In mid-May, we held the view that US breakeven inflation (BEI) rates would continue to rise. This view was based on these arguments:

  1. Core inflation pressures would continue to build gently in the coming months, taking the core inflation rate to above the Fed target
  2. July’s year-on-year headline inflation rate would head towards 3.0% (data to be released in August), largely due to base effects
  3. Financial conditions would remain accommodative, with the US Federal Reserve (Fed) continuing to raise rates by more than priced in by the market, but by less than would be required to fully offset the stimulus from the US administration’s fiscal package
  4. The Federal Open Market Committee (FOMC) would emphasise its tolerance of an inflation overshoot, stressing the symmetry of the inflation target
  5. We believed there was a possibility that the FOMC would, in the next few months, discuss potential changes to the monetary policy framework, possibly looking to adopt a price-level path targeting approach to fulfilling the Fed’s inflation objective
  6. Evidence of ongoing allocations to US Treasury inflation-protected securities (TIPS).

Given our baseline scenario that the FOMC would deliver more rate increases than was priced into the overnight indexed swap (OIS) curve, we also maintained a nominal curve flattening exposure.

From a technical perspective, we nevertheless recognised that 2.25% was an important resistance level for 10-year US BEI rates and that a catalyst would be required to push 01/2028 BEIs through and above that level to a target of 2.40%. That catalyst would ideally be stronger wage growth data and/or core consumer price index (CPI) data.

Exhibit 1: A catalyst is required to push US 10-year breakeven inflation rates higher through the level of 2.25% towards 2.40%

breakeven inflation (BEI) ratesSource: Bloomberg, BNP Paribas Asset Management, as of 19/06/2018

And what risks did you see to your view that breakeven inflation rates could rise further?

We identified several scenarios with the potential to jeopardise our view:

  1. The FOMC could turn more hawkish and signal its intent to offset the fiscal stimulus through accelerated rate increases
  2. Oil prices could suddenly pull back
  3. The US could escalate confrontation with the EU, China and NAFTA partners over trade
  4. A populist coalition might successfully form a government in Italy.

The primary downside risk to our long BEI position was clearly that an Italian 5-Star and League coalition would trigger market stress, with investors concerned about the fiscal implications and the possible consequences for the eurozone.

How do you view prospects for BEI rates now that investors’ concerns about Italy have somewhat receded?

Investor concerns over Italy have at least temporarily tapered off after assurances by Italian Finance Minister Tria and European Affairs Minister Savona that the administration had no plans to exit the eurozone.

Nevertheless, we remain concerned that the administration will, in due course, put forward fiscal proposals that breach EU budget deficit rules, initiating a confrontation with the European Commission, and validating investor concerns over the Italian Treasury’s long-term fiscal sustainability.

 

In other words, we continue to see an inconsistency between assurances that Italy will avoid measures that might lead to an exit from the eurozone and its stated fiscal agenda. Rome will likely deliver its budget proposals to Brussels in September or early October, so market stress could well return as the policy details emerge.

For the time being, however, the soothing words and net redemptions of outstanding Italian government debt are likely to keep yields of Italian sovereign bonds contained.

The risks of a trade conflict have also worried investors in recent weeks. How do you see these influencing inflation-linked bond markets?

In early June, we were treated to a display of Trump-style US diplomacy at the G7 meeting in Quebec. The administration’s refusal to sign the communiqué and its treatment of its EU and NAFTA partners have significantly raised the odds of an escalation of trade conflict, with US tariffs being met with retaliatory measures. Furthermore, recent media reports suggest the administration will proceed with proposals to apply tariffs to Chinese goods, which will, again, be met with swift retaliatory measures.

If enacted, these tariffs would likely be supportive of short-dated BEIs and could be supportive of sovereign bond markets via the adverse impact on growth and economic confidence.

To sum up, what conclusions do you draw now, in the wake of the FOMC’s June meeting ?

In my view, the FOMC’s relatively hawkish June meeting argues for flatter  US Treasury yield curves, an underweighting of duration relative to benchmarks in short-dated Treasuries, and a flat BEI curve. Chairman Powell’s initial rejection of price-level path targeting as a potential innovation for the policy framework is also not encouraging for those reckoning with a rise in long-dated BEIs.

The risks of a trade war have clearly risen since mid-May, and the risks of a renewed flare-up in Italy debt sustainability concerns are also much higher.  As a result, some duration hedge is warranted – hence I’d be inclined to run a small overweight in duration despite what I see as a more hawkish FOMC.

The core US CPI inflation data for May was disappointing, even though recent average hourly earnings numbers were more robust.  This means we are still waiting for a catalyst for further widening of breakeven inflation rates.

Finally, the renewed potential for tariffs, along with a more hawkish FOMC,  means we should look to be overweight front-end BEIs rather than long-dated BEIs.


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Cedric Scholtes

Co-Head Inflation, Rates Committee Chair

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