The inflation-linked bond or “linker” market may seem like the slightly strange little cousin to the main gilt market – everyone knows it exists, but mostly ignore until it does something outrageous. At the moment it is screaming!
Over the next two years, the index-linked market is saying that UK inflation (RPI) will average 3.50%. Current predictions from forecasters are that RPI will be in the 2.2% to 3% region in 2019; to get to the 3.5% average that the index-linked market implies over the next two years, RPI would have to reach the extreme heights of c.4.5% in 2020. Given current levels of inflation, and the outlook for currency markets and oil, it seems very unlikely that we’ll get to these levels north of 4% RPI.
So why is the pricing so extreme? The index-linked market is being used as a political hedge against tail risks, and these risks are becoming more and more like the base case for a lot of investors. It all comes down to expectations of where sterling will move from here.
A no-deal Brexit = £ negative + higher inflation.
A Corbyn Labour government = £ negative + higher inflation.
The Bank of England not hiking rates = £ negative + higher inflation.
So investors are buying inflation-linked bonds on the back of their negative views towards sterling. As they rush to buy “linkers”, they meet little resistance in the market – not many people are willing to take the other side of this argument at the moment.
But at today’s level of £/$ at 1.26 (in the post-referendum trading range of £/$ 1.20 to 1.43), you could argue it has done a lot of the work already. How much further are we able to be shocked by UK political events?
At current pricing we think the inflation market should be done screaming here. It should take a little breather.