The economic downturn marked the beginning of a period in which disinflation concerns amongst international central banks and the broader financial market increased significantly. The international economy was unable to tolerate the substantial rise in real policy rates that was implemented to prevent economic overheating at the height of the expansion. Global equity markets fell sharply influenced by lower expected returns on capital and a positive correction to the equity risk premium.
Although the deteriorating macroeconomic backdrop had implications for both real returns on capital and inflation, the initial market response was heavily skewed towards the easing of inflation pressures as opposed to policy response needed to revive the flagging global economy. For example long-term real yields in the US (TIPS) declined by just 25bp between May and December of 2000, whereas the implied break-even inflation rate fell by almost three times as much. There was a similar response in Euro and UK markets with real yields basically stationary as nominal yields fell to record low levels.
At this time inflation-linked bonds were regarded as a fledgling asset class amongst the international investor community, however, the experience of the more established UK market suggests that we cannot attribute such poor performance in the second half of 2000 entirely to market segmentation and liquidity. The most important consideration is that short-term real interest rates remained high, despite evidence of a significant slowing of economic activity and decelerating price pressures. By the end of 2001, the US Federal Reserve had cut real interest rates to near zero whilst maintaining a bias for further easing. The ECB also cut rates but were unable to be as aggressive given that inflation remained above their 2% policy ceiling. However, long-term real yields in both the US and Europe had barely moved throughout the year, pegged at levels commensurate with a more robust growth environment whilst, implied inflation expectations remained at particularly depressed levels.
It was the beginning of 2002 when we had preliminary evidence of the inflation-linked asset class being re-assessed in the context of the real interest rate easing that had taken place over the preceding 12-month period. Over the next 12 months it became clear that asset allocations were on the rise in both the US and Euro inflation-linked markets, the relatively high real yield level combining with a low inflation-risk premium to generate demand from dedicated funds and off-benchmark sources. Higher oil and gasoline prices created additional demand in the early part of the year as the short transmission lag to the inflation index attracted relative value based investors.
The combination of both permanent and transitory demand drove real yields down whilst pushing break-even inflation spreads wider in both the US and Europe. In the second half of 2002 energy?s contribution to the inflation data began to diminish and break-even inflation spreads fell back sharply as markets responded to further evidence of declining core inflation pressures, however, this failed to derail the ongoing decline in real yields. Last year, geopolitical uncertainty and fears of prolonged disinflation prompted further interest rate cuts from both the FOMC (0.25% in June) and ECB (0.25% in March and 0.5% in June) despite ongoing evidence of macroeconomic recovery. With real interest rates in the US and Europe effectively pinned below zero, markets subsequently bore witness to a substantial rise in demand for inflation-linked assets, building upon asset allocations which had been increasing steadily over the preceding 12 months. This triggered a substantial rise in breakeven inflation spreads during the second half of last year despite a negative seasonal bias and ongoing assertions from the Fed that the risk of further disinflation exceeded that of inflation.
We have seen a continuation of such trends in early 2004 with real yields posting new record low levels in March and break-even inflation spreads increasing to their highest levels since 2000. The present dislocation between real yields and breakeven inflation spreads in the US and to a lesser degree in Europe, clearly highlights these markets? limited capacity to cope with such a fundamental shift in investor attitudes towards inflation and their attempts to immunise such risks from their respective portfolios. The dislocation is now such that one of the arguments previously used to encourage divestment away from traditional fixed income assets is losing much of its validity. That being with respect to volatility, the recent divergence between real yields and inflation expectations raising the risk that future increases in nominal yields could be equalled or exceeded by the real component. Central banks adopting a tighter monetary policy stance could trigger such a reaction.
The derivative markets are partially responsible for the ongoing dislocation in the cash markets so far this year. Fannie Mae and Sallie Mae have issued 5- and 10-year CPI structures in the US (where it is assumed that the issuer has been fully taken out of their inflation exposure via use of an inflation swap), whilst in Europe there has been ongoing activity on an over-the-counter basis. The base of ?natural payers? is yet to develop in the US and Euro markets, therefore it is the underlying cash market that bears the strain. Investors in these markets now face a situation in which the cost of immunising a portfolio against future inflation uncertainty is to accept a low real return over the long-term. Many would argue that the cost of insuring against uncertainty is always high such that low real yields and high break-even inflation spreads can persist until such time as markets approach equilibrium. Therefore, it now appears as if we have the classic underpinnings of a positive demand/supply imbalance, which can basically be resolved if either or all of the following occur:
1. Increased issuance of inflation-linked debt by central governments
2. Establishment of inflation-linked bond programmes by corporations or
3. Increased paying of inflation via swap by entities whose revenues exhibit a natural linkage with inflation
4. Investors taking advantage of attractive asset swap levels generated by the premium in the US and Euro inflation swap curves
In the near term increased government supply has the greatest potential to normalise the prevailing imbalance. The US Treasury has announced a significant increase in TIPS supply going forward with the addition of 5- and 20-year maturities to complement the current 10-year programme. UBS believes that US TIPS issuance could exceed 15% of gross funding in 2005. In Europe, both France and Italy have been quite explicit in their intention to raise the proportion of inflation-linked funding over the long-term and recent comments from Debt Agency officials suggest that Germany will begin issuing inflation-linked bonds (linked to HICP inflation) in 2005. So far in 2004 French issuance as a proportion of total funding has been over 16%, with Italy issuing just over 12% in this form. In the medium term break-even inflation spreads that persistently exceed corporate expectations should translate into increased corporate issuance and/or paying via inflation swap, although accounting concerns with respect to ongoing mark-to-market of such swaps have yet to be resolved categorically. At the same time, LIBOR based investors and hedge funds should be more prepared to exploit the demand for inflation via swap by buying the underlying bonds and swapping out the respective cash flows to generate an enhanced asset swap spread, although this fails to resolve the fundamental lack of supply.
In summary, the now wide acceptance of inflation-linked debt as a separate asset class has unsurprisingly coincided with valuations becoming quite stretched across international markets.
Over time increased government issuance and changing interest rate policy is expected to normalise such imbalances. Irrespective of current valuations, allocation to inflation-linked debt will continue to rise under a regulatory environment which encourages greater matching of assets with liabilities. However, this need not rule out intermittent periods of indigestion along the way.
By Dariush Mirfendereski, Executive Director and Fred Cleary, Director.