Editor's letter

It might seem premature to start worrying about inflation, but that's exactly what some market participants are doing, even as the world languishes in a deflationary slough of despond.

As our columnist John Wraith notes (see p.10), it is not clear how the Bank of England will wind down its quantitative easing programme and restore monetary policy to the straight and narrow, but a swift increase in rates is a likely possibility when monetary easing needs to be reversed.

Barclays Global Investors' Dominic Pegler (see feature p.18) predicts that 12 or 18 months of deflation will be followed by the reverse, leading to a U-shaped rates curve which, of course, would be a major headache for fixed income investors who would see their payments reduced alongside the value of money. Bondholders have recourse to the inflation-linked market, but with supply of linker bonds significantly down, this is likely to become an expensive option.

Rates investment of a different kind is the subject of another piece this month (see p.26) as we investigate the sovereign CDS market. If the cost of bond insurance really is an indicator of credit risk, some of the world's top government borrowers are in worse shape than we'd thought, but even if CDS spreads have been borne out in the past - think Icelandic banks and the Republic of Ireland - this illiquid market is not as clear-cut as it seems.

But while there is a healthy scepticism among investors in sovereign cash bonds about the usefulness of CDS as a measure of risk, the idea of a risk-free benchmark has never seemed less sacrosanct, and the distinction between 'credit' and 'rates' investment never more blurred.

- Matthew Attwood.