This week RPI broke through 5% and CPI broke through 4%. The media are almost universally calling for rate hikes, politicians are starting to voice their opinions loudly, and many investors are worried.
If the market reacts to higher inflation by pricing in more rate hikes, that’s bad news for gilts and index-linked gilts. But for investors such as us who are trading so-called breakeven strategies (ie taking a view on changes on the future inflation rate that’s implied by the bond market), a key question is do conventional gilts or index-linked gilts perform better as the Bank starts hiking? If the market believes the rate hikes will solve the inflation problem then the breakeven inflation rate would be expected to fall and linkers would perform worse than conventional government bonds. If the market believes that a rate hike won’t have any effect, or ascribes low credibility to the policy and its makers, then you’d expect linkers to outperform as the market prices in higher inflation in future.
There is an interesting and frequently overlooked short term dynamic between inflation and interest rates. Mortgage interest payments (MIPs) are a part of the Retail Price Index (RPI) number. MIPs aren’t part of the Consumer Price Index (CPI), the measure of inflation the Bank of England target, although bond markets are (currently) priced off RPI, so that means MIPs matters.
MIPs represent 3.4% of the RPI basket today. So Jim emailed us from the ski slopes saying we should find out what proportion of borrowers are on SVR and trackers, make some assumptions about a plethora of things, and try to estimate what proportion of a rate hike would feed directly into higher MIPs and so into RPI.
What we ended up doing instead, somewhat indolently, was calling BarCap’s inflation guru, Alan James, and asking him what his estimate of the sensitivity of RPI to a rate hike is? Alan was (and is) a great help to us in our preparation for the inflation funds, and I should take this opportunity to thank him! Unsurprisingly, to those who have seen Alan present or who have met him, he had already done this work, and he informed us that his belief is that the relationship is about 0.66, meaning that two-thirds of a rate hike will directly pass through to RPI via MIPs.
The market is now pricing in three 25 basis point rate hikes this year. That means of 75 bps of hikes, MIPs will be pushed up enough to cause RPI to rise by about 0.5%. So the Bank of England hikes rates to lower inflation, and a direct offshoot of this is that RPI actually rises! As this MIPs increase feeds through to RPI, I’d expect to see the front end of the linker curve outperform conventional gilts. It’s not unreasonable to expect breakeven expectations to fall at the longer end reflecting the belief that the dawn of a monetary policy tightening cycle will mean we’ll be moving towards a structurally lower inflation environment. Interesting, these unintended consequences…