Are investors growing complacent about inflation? If so, it wouldn’t be the first time.
US inflation was higher than expected in January, figures published on Tuesday showed, with the headline number reaching 3.1 per cent year on year versus consensus estimates of 2.9 per cent. The release shows inflation may be stronger and stickier than the market - and the US Federal Reserve - were expecting and it was immediately followed by a rise in breakeven inflation and price moves that imply interest cuts at a later date than previously expected.
Yet this initial reaction left US 5-year breakeven inflation, calculated as the difference in yield between 5-year Treasuries and 5-year Treasury Inflation Protected Securities (TIPS), at still only 2.3 per cent. The idea that US consumer price index inflation will average at 2.3 per cent year on year over the next five years seems somewhat optimistic given US core CPI - which strips out volatile items like food and energy - came in at 3.9 per cent year on year for January 2024.
Keep in mind that, more often than not, market pricing underestimates upside inflation risks. This week’s Chart Room - drawing on data from the last quarter of a century - shows US TIPS have delivered better returns than their nominal counterparts of the same maturity in 17 of the last 25 calendar years.
An inflation-linked bond will outperform its equivalent nominal bond when inflation turns out to be higher than expected. As with nominal returns, linker returns are inversely related to changes in interest rates. The sweet spot for linkers is therefore a period when realised inflation comes in above expectations but not so much that it sets off aggressive hiking by central banks. Although past performance should not be taken as an indicator of future results, history shows that it’s not unreasonable to expect at least the first part of this equation to play out.
