Slowing economy hits inflation markets

Poor economic prospects and falling commodity prices have changed the face of inflation markets around the world, easing the shortages that constricted them earlier this year.

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