Fixed income
Virulent inflation may have peaked – but does further danger lurk?
3 min read 26 Apr 23
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Markets speak to the fluidity of the environment around them. Over the past year, they’ve delivered verdicts on government economic programmes, central bank monetary policy and the energy sector – but how are the markets perceiving inflation today since it became structural a year ago?
“Overall, markets are still priced for the Covid fiscal and monetary response – in other words, a one-off event that’s unlikely to be repeated.”
"At the moment the markets are pretty relaxed about the idea that we’ve seen the peak of inflation,” says Miles Tym, Senior Portfolio Manager for Government Bonds at M&G Investments.
The most striking feature of the chart above shows that as Covid-19 struck, a lot of disinflation was being priced in and by 2022, it became apparent that inflation would be spiking high. US breakeven spiked as high as 3.73% while the UK briefly touched 5%.
Despite inflation peaking and remaining elevated – certainly in the UK – things have come a long way. If we look at the current breakeven rates in both the UK and US, they are not dramatically elevated from where they were in the two to three years preceding Covid and the response measures that followed.
“The markets are pricing a little bit of a probability that economies are going to be prone to inflation going forward, but they’re not pricing in anything like the dramatic spike of inflation that we’ve seen over the last year or so,” observes Tym.
Looking beyond the noise
The chart above demonstrates just how much the UK market is currently prepared to look through inflation as a temporary phenomenon. The chart shows that from 2021 to early 2022, inflation in the UK and US were both going up in tandem, but the inflation rate in the latter had decisively peaked and has since fallen from 9% to 6%.
In contrast, UK inflation has continued to grind higher over the last few months and there is an enormous differential between inflation rates in the US and UK as per the chart. Despite this, the 5-year inflation expectations in the two markets are not out of line with long-term history and inflation is priced in with a 1.22% difference in the UK over and above the US over the next five years – a long way from the 3.68 priced for UK inflation versus the current inflation rate of 13.8%.
“The market is expecting an awful lot of that to fade quite rapidly,” says Tym. Whether this is justified is the big question.
“As a central expectation it probably is, but there are some dangers around it,” says Tym. “The reason a lot of it is justified is because quite a lot of it relates to energy prices and the delayed impact of that coming through in the pricing of inflation.”
Wait-and-see mode
The UK has been bearing the brunt of large hikes in utility bills over the past year (April and October 2022) and large hikes in the Retail Price Index (RPI) subsequently followed. In March 2023, the UK Chancellor announced the extension of the Energy Price Guarantee (EPG) by a further three months until June 20231. Should utility bills come down in July, this could shave several percentage points off the UK’s RPI number.
Overall, markets are still priced for the Covid fiscal and monetary response – in other words, a one-off event that’s unlikely to be repeated.
“In the US, market inflation expectation has come down sharply as a response to tightening financial conditions but the moves in the markets are not as dramatic as the things that we’ve seen over the last two to three years for the time being – but we’re in wait-and-see mode,” says Tym.
1 UK government, “Energy Price Guarantee extended for an extra three months”, 15 March 2023.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
