In focus

Inflation-linked bonds: is Covid-19 stimulus boosting their appeal?

Central banks have reacted rapidly and aggressively to mitigate the negative economic consequences of the Covid-19 crisis. They have provided unprecedented liquidity injections and increased asset purchases, among other measures.

Their official objective remains to achieve target rates of inflation, but we have seen central banks’ policy remit become ever broader, particularly through the explicit support provided to the private sector.

We expect this level of enhanced stimulus to remain in place for a protracted period, both to support the real economy and to keep borrowing affordable for governments.

Would central banks welcome a rise in inflation?

Increased stimulus from central banks will mean structurally lower interest rates and in all likelihood a rise in inflation expectations, from the currently subdued levels. The starting point for inflation expectations is low and more attention has been focussed on shorter-term negative economic pressure. In Europe, for instance, deflation risk has been mentioned once again. Central banks will welcome a rise in inflation and looking forward are likely to tolerate above-target inflation to sustain longer term price stability.

Meanwhile, the sharp increase in fiscal stimulus globally has combined to help support future growth as governments begin to emerge from lockdown and attempt to adjust to a new normal. The increased money supply from stimulus measures combined with cheap financing of debt could certainly be inflationary. This could see a marked divergence of inflation risks across countries.

Do low inflation expectations underestimate the impact of loosening financial conditions?

While financial conditions alone could boost inflation expectations, a lot depends on how strongly aggregate demand recovers. This relies on positive business and consumer sentiment. While negative and low interest rates may dissuade households from too much precautionary saving, consumers may still feel vulnerable in the face of a recession. Demand for goods and services may remain depressed as a result.

However, as the chart demonstrates, historically, loosening financial conditions (taking into account interest rates, the US dollar exchange rate, equity prices and corporate bond levels) have tended to result in rising inflation expectations. While the March crisis and liquidity squeeze saw a sharp tightening in financial conditions, this has quickly reversed and conditions are once again loosening. 


Shape of the recovery is key

As stringent lockdown measures are gradually removed and countries transition to a “new normal”, the shape of the recovery will have implications for inflation.  The shape of the economic recovery remains to be seen, but most market participants are expecting it to be “U” shaped.

This slower pace of recovery is likely to encapsulate lower inflation risks relative to a sharper rebound. However, with inflation expectations currently so low, even a small shift in sentiment could be significant for inflation expectations.


Longer-term structural inflation forces will continue to have an impact

Time horizons are an important consideration. Most major central banks have struggled to achieve their inflation targets for some time mainly due to deeper, longer term changes such as technological advancement, demographics and inequality.

Some of these disinflationary factors will have been exacerbated and brought forward due to Covid-19. For example, technological advancements could well be sped up. For some sectors of the economy, this change will be permanent.

Conversely, the reversal or reduction of globalisation (another longer-term structural theme), could be inherently inflationary and this process may also have been accelerated by Covid-19. One of the major consequences of globalisation in recent decades has been increasingly global supply networks and lower labour costs. A reversal of this trend (which was already in evidence prior to the pandemic) as a result of reduced global connectedness, through both global trade and a reversion to more localised labour forces, risks raising inflation due to limited competition.

Opportune moment to take exposure to inflation

So, while central banks and governments are committed to stimulus measures, the extent of any increase in inflation will be contingent on the strength of the economic recovery. The lifting of restrictions could unleash a wave of pent-up demand. Or negative economic conditions, such as rising unemployment, could lead to a rise in precautionary savings. Longer term forces will also play a part.

However, with inflation measures (particularly core measures) having fallen significantly, market based inflation expectations are currently low. While some investors may judge the risks to inflation are somewhat low, the current cheapness of inflation linked bonds could make them an attractive diversifier as part of a broader portfolio, as well as a hedge against the corrosive effect of rising prices.

A final point is that, with countries around the world reacting differently and at different stages of recovery, with some more constrained by deficits, there could be opportunities to generate returns by allocating actively across inflation linked markets globally.