ANALYSIS-UK linker frenzy sends investors abroad for inflation hedge

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* Scarcity of labor and goods fueling UK inflation

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* UK ‘break even’ rates have risen in recent weeks

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* Blaming ‘inflation tourists’, says a trader

* Funds say US, Australian, Euro zone bonds more attractive

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* Stricter BoE policy, technology can reduce inflation

LONDON, Oct 13 (Businesshala) – Britain looks like a place where investors urgently need to hedge against inflation, yet many say trading in domestic bonds is driving price pressure so high that They have become too expensive to consider.

Inflation-linked government bonds tend to rise in price because their principal and interest payments go up and down as prices change.

Interest in them in Britain – including a securities trader known as an “inflation tourist” – has soared as labor and commodity shortages fueled inflationary fears.

Even in normal times, British linkers enjoy a huge demand from local pension funds, especially defined benefit schemes that promise to account for inflation when paid out. This lowers the yield and increases the breakeven – the underlying inflation rate.

They pay returns linked to the Retail Price Index (RPI) rather than the consumer price index used by the Bank of England. Since the RPI is 0.8% to 1% above the CPI, inflation expectations should be dialed in accordingly.

But even after accounting for that gap, fund managers say they are being forced to seek the same protection overseas as the UK market, with investors already positioned for low inflation being squeezed. done, has become more detached from the fundamentals

One-year indexed linked gilts currently show an inflation rate of 5.8% while five-year linked gilts show it at 4%.

The BoE expects consumer price inflation to rise above 4% for some time at the end of 2021 and then to subside.

Investors say poor value for money in the linker market is especially the case, given the recent aggressive reassessment of the British government’s strict BoE policy in the bond market.

Two-year UK yields have risen 42 basis points over the past month and a half, while two-year US yields are up 14 bps and German by only 5 bps.

demand/supply imbalance

“It’s a very rich premium for us. There are cheaper options out there,” said John Taylor, co-head of European fixed income at AllianceBernstein.

As inflation expectations rose, Taylor sold British government bonds, adding to the risk of inflation-linked bonds in Australia and the United States, where pricing does not appear to be so high.

The UK 2-year 2-year forward inflation swap predicts a 4% inflation rate, double the BoE target and up from around 3.83% in early September.

The US and euro zone counterparts, at 2.77% and 1.78%, have risen even higher, but both remain very close to their central banks’ inflation targets.

Royal London Asset Management’s Head of Alpha Strategies, Paul Rainer, has also dropped UK linkers in favor of Australian, US and euro zone inflation-linked bonds, as well as Japanese, where breakevens are close to zero.

These provide better ways to account for rising British and global inflationary conditions, Rainer said, calling UK linkers “extremely overvalued”.

According to an inflationary securities trader at a major bank, part of the break-even boom is down to “inflation tourists” — investors typically not involved in the market, but who seek sudden protection.

This has exacerbated the demand/supply imbalance in a market where some 1.7 trillion pounds ($2.3 trillion) of inflation-linked most pension fund liabilities chased products worth less than £500 billion.

“Such a camp adds pressure for the breakeven to move higher and this generally means that headline inflation will begin to peak and then reverse,” the trader said.

Data from Morningstar shows that assets held in sterling inflation-linked bond funds domiciled in Europe – a proxy for the broader linker market – rose to 16.9 billion euros in August, down from the previous month’s record high.

He received 876 million euros in net cash in the first eight months of 2021, his biggest run since 2017.

inflated expectations

Fahd Kamal, chief investment officer at Kleinwort Hambros, said inflation expectations were “far above what actually happened” for years. Slow growth and demographics are “far greater forces than the short-term supply issues that markets get excited about.”

“Presumably, it is pushing inflation by a few percentage points over historical averages,” said Kamal, who has turned to US securities for a “better gauge of global inflationary pressures.”

Toscafund Asset Management’s chief economist, Savas Savouri, among others, believe that the CPI basket itself needs overhauling as it does not account for the deflationary effects of the technology.

While the linkers indicate a CPI of 3.2% over five years time, they expect the actual reading to be 2%-2.5%.

($1 = 0.7355 pounds)

Additional reporting by Sujatha Rao and Dhara Ranasinghe; Editing by Sujatha Rao and John Stonestreet


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