Did central banks lose control or did the investors lose their nerve?
Marion Le Morhedec and Jonathan Baltora, managers of the AXA WF Global Inflation Bonds fund at AXA Investment Managers (AXA IM), discuss whether central banks have lost control or investors have lost their nerves.
Central banks’ loss of credibility has been one of the major investment themes since the start of 2016.
One of the main indicators has been the fall in inflation breakevens reflecting investor fears that we may be entering a deflation spiral that central banks would be unable to stop.
However, the fall in oil prices has massively influenced inflation expectations and drawing the conclusion that central banks have lost credibility because of this is overblown.
The oil price impact on inflation is significant. We estimate that 80% of inflation volatility may be explained by oil.
However, food and oil price fluctuations only have a short-term impact on inflation. Assuming stable oil prices, headline inflation rates will gradually increase towards core inflation rates in the later part of the year.
This is an encouraging picture for the inflation linked bond market as inflation expectations have become very sensitive to short term inflation developments. We now expect these to better reflect core inflation dynamics.
The US 10-year inflation breakeven, which is a measure of the average annual inflation over the next decade, is trading 0.7% below the current rate of core inflation. We believe that this is excessively pessimistic.
Since the Lehman fallout, this situation has been seen only twice and resulted in a sharp increase of inflation breakevens. The first time was in the exact aftermath of the Lehman failure and the second time in the darkest hours of the euro area crisis.
Those two situations were followed by a strong rise in inflation expectations over the subsequent six months.
Interestingly, the current situation in the inflation market is the exact opposite of what happened in 2012. In 2012, markets were pricing higher future inflation than current inflation, suggesting that central banks had lost control, facing the risk of high inflation.
On this basis, we have added inflation-sensitive positions to our portfolios especially in the US Treasury inflation protected securities (TIPS) market where we see the greatest opportunities over the coming months based on the simple observation that inflation linked bonds do not really forecast inflation, but are instead attracted to the current core inflation rate.
We do not sit in the camp of those thinking that central banks have lost control, but instead believe that a volatile start to 2016 may have led some investors to lose their nerve…