Slowing economy hits inflation markets

Expectations of inflation have fallen since WTI crude oil prices peaked at $145.29 on July 3 - oil and other commodities have generally fallen since, and economic forecasts have generally been gloomy. This has driven down prices of inflation-linked bonds outside the UK, said inflation strategist Chris Lupoli at UBS in London.

"Inflation-linked pricing is driven by whatever drives expectations of inflation," Lupoli said. "For non-UK bonds, demand is driven by accrual, and as commodities come down, people don't want to own the bonds because they expect accrual to be negative."

Breakeven rates for US Treasury inflation-protected securities (Tips) have fallen, reflecting the change in inflation expectations. The breakeven rate is the spread between a Tips and a standard Treasury bond, reflecting expected inflation over the life of the bond. On July 4, the 10-year breakeven was 260 basis points; it has now fallen to 216 bp.

"When the market is in a negative phase for breakeven, you'd rather be in, say, Treasury than Tips; the cross-asset guys have got better areas to be in," Lupoli commented.

In the UK, where the market is traditionally driven by end-user demand rather than by inflation expectations, supply is still tight, says Barclays Capital's head of European inflation trading, Benoit Chriqui.

"The UK inflation market is still suffering from a supply/demand imbalance," he says. "Corporate supply has not returned to the market in a significant way as of yet. On the other side, inflation demand has slowed down, both because of high outright levels, and because of widening of bid/offer spreads. This slowdown in demand, along with the sell-off in commodity prices, has helped stabilise the breakeven market, which has traded in a tight range over the past three months. This stability has not really helped bring back liquidity to the market, but it is a first step."

And there is little prospect of an increase in supply from the government side: the UK Debt Management Office reiterated in its annual report, published yesterday, that it would only increase inflation-linked issuance slightly, from £15 billion last financial year to £18 billion in the year ahead.

See also: Inflated or deflated? 
Inflation dislocation