Judgement Day – RPI Damp Squib

Today has seen the release of the decision by the National Statistician about what to do with the Retail Prices Index. We were told of the consultation in September last year, and were presented with 4 options, ranging from 1) to do nothing, to 4) to make RPI as much like CPI as possible.

Our view was always that the consultation arose as a result of the desire to correct an error made in the clothing component of RPI in January 2010 see blog. This change had seen the ‘wedge’ between RPI and CPI anomalously and erroneously increase by close to 1% following its implementation. We therefore believed that it was perfectly appropriate for the National Statistician to correct this error, and so we were expecting to see Option 2 materialise, which most closely targeted correcting this source of the wedge.

UK linkers had noticeably underperformed other markets since the announcement of the consultation. The market had initially started to price in a 30 to 50 basis point reduction in the wedge of RPI over CPI in expectation of Option 2′s intention to rectify the error.  However, as Judgement Day approached nervousness increased in the linker market as people started to worry that the more severe options could be implemented.

Were Option 4 to have been recommended today, the wedge of RPI over CPI would have been reduced by approximately 100 basis points. This would have been a severe and brutal change for the index linked bond market. All else remaining equal, this change would have seen breakevens on index-linked bonds fall by approximately 70 basis points (allowing for 30 basis points of underperformance already priced in).  To put it another way, this would have see the price of the longest index-linked gilt, the UKTi 0.375% 2062s, fall from 107.7 to about 85, a fall of 21%. Today, things really could have got nasty!

But the decision today has been Option 1. No change. Whilst highlighting that “the RPI does not meet international standards” and recommending that a new index be published, Jil Matheson “also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. For the release, go to this link.

All the lobbying that we – and some others – have been doing behind the scenes has been worth it. In the Financial Times today, Chris Giles (who was on the Consumer Prices Advisory Committee) stated that the ONS rejected the committee’s advice in the face of  ‘overwhelming opposition to changes in the calculation of the RPI’.  The market has recently opened, and is removing the expected reduction of 30 basis points or so from Option 2. Breakeven inflation rates at the moment are up by 37 basis points at the 10 year part of the curve and by 22 basis points at the long end. The 2062 index-linked gilt is up by 12 points in price terms, and the whole linker market is rallying in the relief that no change is being made…

…for now! We will soon see the creation of a new RPI index, called RPIJ. This effectively makes RPI equal to CPI through making the older RPI index more modern by removing arithmetic mean and replacing it with geometric mean. This will be run in parallel with the old, untouched index. But it suggests that this debate is not over forever. We could again see recommendations to move from RPI to RPIJ, but more likely, we will soon start to debate moving the index-linked corporate bond market from RPI linkage to CPI linkage.  The creation of RPIJ does seem a little irrelevant, where a new index has been created that few people will care about given that inflation linked bonds will continue to be linked to RPI and the government is clearly dedicated to linking other forms of government compensation to CPI.

Ultimately, though, even if we had seen a brutal reduction in RPI today, I still think that the strong case could be made to want to own UK index-linked bonds over the medium and long term. And changing the calculation to option 4 could have saved the Treasury a whopping £3bn per year, so while the decision to make no change has been great for inflation linked bond holders, it’s not so great for the UK’s coffers.   Finally, the strong opposition to the RPI changes gives you a good idea of how hard it will be to implement austerity measures, and if we aren’t going to get out of this debt crisis through austerity, then the likelihood of us getting out of it with the help of inflation has just increased a bit!


Crazy weather and the butterfly effect on inflation

It seems that the wettest “summer” on record in England is not only playing havoc with the M&G cricket team’s schedule, it is also having a massive impact on the nation’s butterflies. Sir David Attenborough is asking people to participate in the world’s biggest butterfly survey – The Big Butterfly Count – to see how the butterfly population has fared after all the wet weather we have been having. So get out in your garden and see how many butterflies and moths you can count in 15 minutes – counting butterflies has been described as “taking the pulse of nature”.

It should be noted though that England is not the only country that has been experiencing adverse weather conditions. In the US there have been wildfires in Colorado, a heatwave across the eastern seaboard, and a “super derecho” which caused mass destruction from west of Chicago to east of Washington, D.C. Russia has experienced flash flooding in the Krasnodar region and the drought experienced in southern Russia has expanded into western Ukraine and southeastern Europe.

For investment markets, extreme weather events tend to result in a lower supply of soft commodities like maize, wheat, soybeans and corn. Because supply is now expected to fall due to these extreme weather events, the price of soft commodities has sky rocketed over the course of 2012.

Soft commodities rising fastOf course, higher food prices means higher inflation numbers. In the UK, food makes up 11.4% of the RPI index and 9.8% of the CPI index. In Europe, food makes up 13.9% in the HICP. In the US, food is 14.2% of the CPI. The recent price increases for soft commodities are currently not expected to result in higher overall inflation.

That said, if we do get some pass-through, central bankers would tend to describe the increase in inflation as temporary. Central bankers prefer to look at “core” measures of inflation that exclude potentially volatile categories like food and energy. Mike recently wrote that the state of the global economy is quite poor, so it is more than likely that the central bank authorities will describe any increase in inflation as temporary and that real economies remain weak. We have been describing central bank regime change for a while now, and it appears clear to us that central banks aren’t really all too fussed about inflation anymore. It’s all about unemployment and debt.

However, inflation affects everyone. We can debate whether this is fair or not, as the average consumer doesn’t exclude food and energy from their basket of goods, but rising food prices are arguably an even bigger issue in EM countries. The following chart highlights the weight of food in the inflation basket across the continent of Europe. For EM countries like Romania (29.7%), Turkey (24.3%) and Lithuania (23.6%), the food bill is a substantial amount of money to the average citizen of these nations.  In China, the weight of food is close to a third and in India it is almost half. Many of these countries are currently embarking on monetary policy easing and if food inflation continues for a sustained period of time, then this could put these policy easing plans at risk.

% weight of food in HICP index in EuropeAs I mentioned last year, the  Food and Agriculture Organisation (FAO) of the United Nations is a great source of information on agricultural production and the outlook for food commodity prices. And as I said last year, their agricultural outlook does not make for comforting reading. The chart below shows their nominal price forecasts for crops, livestock and fats out to 2021. There is a continued increase in commodity prices particularly for oilseeds, beef, and fish. The FAO highlight that the key issue facing global agriculture is how to increase productivity in a more sustainable way to meet the rising demand for the “four F’s” – food, feed, fuel and fibre. It is forecast that agricultural production will need to increase by 40% over the next 40 years but total arable land will increase by only 5%. Increasing productivity and developing new technologies will be crucial.

Price trends of agricultural commodities (nominal)So keep an eye on those butterflies. They could very well be a leading indicator to food prices and inflation outcomes.


Why the UK has a real rate problem

The financial crisis is resulting in the authorities, the public, and investment managers seeing things they did not expect to see. Today’s headline RPI level of 5.5% is a record 5% above the Bank of England base rate of 0.5%, resulting in a negative real interest rate (base rate – RPI) of -5%. This is the most divergent I’ve seen this in my 25 years in the city (see chart).


The bond bears think that the relationship will be normalised by a rapid increase in the base rate and a fall in inflation towards more normal levels. The bulls would suggest that the inflation measure reflects temporary factors and will therefore decline to more normal levels with only modest rate increases by the Bank of England.

However, the fate of the base rate and inflation does not sit with the bond bulls and bears but with the Bank of England Monetary Policy Committee (MPC). Their policy of ultra low rates means the MPC is missing their CPI based inflation target of 2% on a regular monthly basis. Since September 2007, inflation has been above 2% in 35 out of 42 months.

Why are they doing this? Presumably the MPC believes that the high inflation rate will be temporary in nature, however there could be other motives behind their policy stance. The Bank of England via QE has previously determined that interest rates had reached their effective bounds in stimulating the economy, as a central bank cannot achieve negative nominal rates. Therefore in order for their rate setting policy to work they have become very relaxed with negative real short term interest rates as they pursue a policy of cleansing the system of its financial hangover from the credit bubble as best it can.

Lets hope from  the Bank of  England’s point of view that the hair of the dog cure of ultra low real rates is actually an appropriate diagnosis of  a fragile, staggering UK economy. Otherwise we could all end up in a dizzy inflation spiral.


Inflation Hedging for Long-Term Investors – the most important academic paper you will read this year

You would have to be living under a rock to not notice the increasing number of articles dedicated to the topic of inflation. The increase in inflationary articles has almost been as dramatic as the increase in inflation itself. Even 3 out of our last 4 blogs have been on inflation. Unsurprising really, seeing as we are bond investors.  Looking elsewhere, the pundits have decided to focus on the idea of how an investor can protect a portfolio of assets from inflation. Having done a lot of research on the topic here on the M&G bond team, we would like to draw your attention to an IMF working paper entitled “Inflation Hedging for Long-Term Investors” which adds an interesting angle on the debate.

Alexander Attie and Shaun Roache tackled the subject of inflation hedging front-on, and discovered some surprising results in the process. Attie and Roache had a look at the asset classes that typically make up the core of long-term investor portfolios – cash, bonds, equities, property and commodities – and measured the sensitivity of asset class returns to inflation over a one-year horizon.

The authors found that “the ability of cash to hedge against inflation is heavily influenced by the prevailing monetary policy regime”. This is unsurprising given the success central banks have had in anchoring inflationary expectations since the 1980s. It tends to be the case that when inflationary pressures increase, the central bank will act by hiking up interest rates.

The most recent experience suggests that banks have been more willing than usual to keep rates on hold despite a pick-up in inflation. In the attached chart, we can see that inflation both in the UK and Europe has been running at a level that is higher than short term cash rates as measured by LIBOR and EURIBOR. This would indicate that whilst cash has traditionally been a partial hedge, since the financial crisis this has not been the case.

Both bonds and equities underperform if inflation increases. Looking at the analysis of returns since 1973, for a 1 percentage point increase in inflation over 12 months, the nominal annual return on  a US Treasury bond benchmark fell by -1.33%. US corporate bonds fell by -1.91%. Equities experience even larger losses, with the same 1 percentage point increase in inflation leading to a fall in returns of the S&P 500 Index of -2.59%. Property, as measured by the FTSE NAREIT index does even worse, with returns falling by -3.48%.

Many investors point to the fact that commercial property rent reviews may be indexed to an inflationary measure, like RPI in the UK or HICP in Europe. However, because owners of property have generally levered their deposit through a loan, the cost of financing that loan will rise if interest rates increase to combat rising inflation. Pricing pressures on property arise when financing costs increase to material levels, causing both retail and commercial property prices to fall.

Commodities, as measured by the CRB Index, provide an effective hedge under this analysis with a 1 percentage point increase in the US CPI resulting in an increase of 3.77%. The gold spot price does particularly well, with the price increasing by 6.87%.

The attached chart shows the effects on nominal returns of various asset classes for a 1 percentage point increase in the rate of inflation over a one-year period. The results tend to be more conclusive for the post-Bretton Woods period since 1973. As you can see, all the major asset classes are assessed and all suffer after an increase in inflation, except commodities.

As Attie and Roache point out, “for long-term investors, a 12-month horizon is likely to be too short”. The lads use a long-run model to assess whether the returns exhibited in the short-run by asset classes are similar over a longer period (20 years).

In the attached chart, an elasticity of 1 indicates that the asset class provides a perfect hedge against inflation shocks and that real returns for the various indices remain unchanged.

The authors find that over a 20-year period, “cash returns do increase in response to an inflation shock, but the response is very gradual and less than full… Over time, cash begins to recover on an inflation-adjusted basis, but this process plays out over a very long period”. As discussed above, the move towards inflation targeting by central banks may mean that cash returns are more sensitive to inflation than has historically been the case.

Long-term treasury returns get whacked by inflation, as we would expect.  Interestingly, these losses tend to peak around the 3 year mark of the 20-year time horizon with real return losses of nearly 2 percentage points. After this peak, yields and prices eventually stabilise and returns from treasuries improve due to higher running yields.

The authors find that the inflation shock is “likely to lead to higher long-term real yields, increasing the total return of bonds once the effects of the shock have been fully priced-in”. Additionally, the bond coupon is reinvested and bonds mature at higher yields. A bond investor doesn’t get fooled again after buying the bonds at low yields and inflation comes back.

With the risk of sounding like a one-eyed bond guy, I think I will directly quote Attie and Roache regarding equities:

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample. After 1 year, equity returns are… 0.9% lower in real terms due to the inflation shock and the decline in returns bottoms out after about 3 years… [for a] 3% loss in real terms… Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

The authors note that “this result does not imply that equities underperform inflation over the very long run; indeed there is ample evidence that equities outperform other traditional asset classes in real terms over long horizons”.

We think that what really matters for equity returns in an inflationary environment is the type of inflation an economy is facing. Is it demand-pull or cost-push inflation?  In general, inflation is caused by demand-pull rather than cost-push factors. Demand-pull inflation is a sustained increase in the prices of goods and services resulting from high demand. No one is worried about economies overheating at the moment and thus demand-pull inflation. Arguably economies like Europe and the UK are facing cost-push inflation with the main cause being rising taxes and imported inflation. In an environment of cost-push inflation like the early 1970s, equity returns tend to suffer.

And whilst commodities do very well over the short-term, they tend to suffer over the long-term as the effects of inflation causes commodity prices to fall gradually over time. Commodity prices begin to fall, normally after a period of 2 years. Some reasons put forward for this relationship is that prices fall as supply comes on-stream, or demand for commodities is reduced because of higher interest rates or a business cycle slowdown.

Attie and Roache conclude that these findings have major implications for long-term investors, particularly if those investors have strong views about the path of inflation. In the words of the authors, “This is particularly true for “non-consensus” views in which investors may expect inflation surprises, whether positive or negative”.

Again, on equities I will leave it to the lads to express their conclusion:

Our results suggest that for investors who do not take tactical portfolio positions, the rationale for holding equities should be based on a very long-term horizon to ensure that the effects of inflation cycles average out. Investors with the scope to tilt their portfolios could underweight equities relative to their strategic benchmark in anticipation of higher inflation, but it may be more efficient to use other assets given their stronger and more consistent reactions”.

The paper is fairly damning for those who think they can inflation-hedge an investment portfolio: “among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst”.

So what can investors do about protecting themselves from inflation?

Index-linked bonds (both government and corporate) are the only “traditional” asset class that will protect investors from inflation provided they hold the bond to maturity. As a buy and hold strategy, linkers work great. Because both the coupon payments and principal are adjusted in line with movements in a price index, an investor will be fully hedged against inflation (again – provided they hold the bond to maturity). Be warned – government linkers tend to be long duration securities, with the average UK and European linker having a duration of 15 and 8 years respectively. So investors have a lot of interest-rate risk in owning these bonds. Corporate linkers tend to have a shorter duration profile and it is important to have some short duration linkers in a portfolio as well. Don’t forget that there are also trading costs and there will be some price volatility as investors expectations for inflation change.

Inflation derivatives like swaps and options will also do the job, but it should be noted the markets for these derivatives are in infancy and considerably less liquid.

All in all, a very interesting paper that the pundits should try and get their heads around. It is one thing to look at a long-run chart of returns of the various asset classes through history, quite another to try and protect a portfolio of investments from future inflation.

Disclaimer – I don’t want to be accused of stealth marketing because that is not what the bondvigilantes blog is about, so here is a blog that Jim wrote about the launch of a couple of funds that aim at protecting investors from inflation. For what it is worth, we don’t think inflation is an issue over the medium term but think it will be sticky in 2011. Check out our views on inflation here.

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Foreign investors still love gilts

After December’s big sell-off in US Treasuries on the back of fears about the US’s creditworthiness, and the surprise at yesterday’s record monthly budget deficit in the UK, there’s been a lot of talk about a bond market “buyers’ strike”.  In particular the western bond markets’ reliance on Asian central banks has made many nervous that a change in risk appetite there could result in strings of uncovered bond auctions and significantly higher yields as borrowing costs rise.

Perhaps this is overly pessimistic.  Although this data is for Q3, and therefore doesn’t reflect the most recent wobble in confidence, it shows that foreign investors bought £22.115 billion of UK gilts in that quarter – and £77 billion over a 12 month period, a massive help for the UK’s financing requirements.  This shows that overseas investors are confident that the UK will remain a AAA rated bond market (with the debt burden tackled by the Tory/LibDem austerity programme), and also reflects a safe haven status at a time when peripheral European bond markets have been collapsing.  So no need for panic in the UK gilt market yet – but if yesterday’s numbers reflected the start of  a string of poor budget deficit numbers, and inflation remains higher than most gilt yields (you don’t earn CPI until you lend out to 8 years on the yield curve, and you don’t earn RPI anywhere outside of inflation-linked gilts) then there will be cause to worry.

Here’s the link to the statistics – the gilt numbers are on page 100, column F.3321.


UK linkers becoming stinkers

In the recent emergency UK budget it was announced that public sector indexation would change from RPI to CPI from April 2011.  Now, the government is proposing moving private sector schemes and the Pension Protection Fund (PPF) indexation to CPI too.  As Pensions Minister Steve Webb argued, it makes sense switching to CPI as it’s the measure that the BoE targets and (slightly more dubiously) CPI is a more appropriate measure of pension recipients’ inflation experiences.

RPI has historically been higher than CPI, exceeding CPI by 0.55% on average over the last twenty years, so if the differential between the measures continues in future then this proposed change would reduce pension fund deficits but would penalise scheme members if (and presumably when) it is implemented. 

The problem with this proposal is that you can’t buy CPI linked assets in the UK – they don’t exist.  While the correlation between RPI and CPI is reasonably close as you’d expect, the difference was as high as 3.1% in 1989 and is currently a relatively large 1.7%.  RPI linked assets are still a better hedge against inflation than any other asset class, but there will definitely need to be CPI linked assets at some stage. 

It may be possible to restructure the existing RPI linked index-linked gilts, but the easiest thing would be to issue new CPI linked index-linked gilts.  This would make the RPI linked assets currently in existence pretty redundant.  The good news is that this change, assuming it happens, will likely take years rather than months to implement and even then could well be gradual.  Furthermore, in the meantime investors have no choice other than to continue buying RPI linked assets to hedge against inflation. 

But it’s clearly a negative for inflation linked gilts overall, and we’re seeing that in terms of price action today.   Longer dated index-linked gilts are getting hit hardest, partly because they’re longer duration so are more sensitive to changes in yields, and partly because the biggest buyers of long linkers are the pension funds.  At the time of writing, UKTI 1.125% 2037s are down over 2% so far today, while the UKTI 0.5% 2050s are down 3.5%. 

Linkers maturing in 20 years or longer have now been in a bear market year to date, which is quite incredible given that long dated conventional gilts (ie those maturing in 15 years or longer) have returned over 13% over the period.   The significant underperformance of linkers has come about despite the UK inflation rate rising significantly this year, with the year on year rate of CPI climbing from 2.9% in December to 3.4% in May – as mentioned in October here, changes in the real yield is a much more important driver of returns for longer dated index-linked gilts than changes in short term inflation.


Not quite a letter – CPI comes in at 3%

CPI inflation in the UK hit 3% in December. Anything higher than this and the Bank’s Governor Mervyn King will have to write a letter to Gordon Brown explaining why inflation is so high. It probably won’t read “Dear Gordon, the reason inflation has busted out of the target you set for us is that we’ve kept real interest rates at exceptionally low levels for too long. Yours, Mervyn.” – but it probably should.

The inflation rise was driven by higher transport costs (train and tube fares), furniture and household goods, and recreation and culture. Most worrying was the rise in headline RPI to 4.4%, from 3.9% previously. The latest survey from IDS, a pay consultancy, suggests that in the most recent wage settlements, the benchmark has been the RPI number, rather than the lower CPI number. Higher and higher wage increases could cause inflation to start getting out of control. The most important job the Bank now has to do is to control inflation expectations – this will partly be down to words, with strong anti-inflationary speeches required; but it also requires action, and that includes a further rate hike in the next couple of months.

Elsewhere, commodity prices are worth a comment. The major commodity indices have fallen back a decent way over the past year (CRB down over 15%), largely driven by the setback in the oil price, but also in some recent falls in metals like copper. All good news for inflation, but while there’s good news in these “hard” commodity prices, the “soft” commodities have seen some impressive rises of late. In particular the price of corn has just jumped to a 10 year high (to $4.165 a bushel) on the back of falling stockpiles. Demand from ethanol producers has driven this shortage, and the dramatic rises in corn prices is causing some social unrest in some emerging economies where it’s a staple food. Worth watching.

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Inflation – 2006 sector breakdown

Looking at the broad categories of the UK’s RPI numbers here’s a brief breakdown of where the inflationary – and indeed deflationary – pressures are occuring. The most recent inflation number we have is for November. The headline RPI was +3.9%, year on year.

 Components rising more quickly than average
- Fuel and Light: up 29.5% from a year earlier. Although crude oil prices were only up 11% over the same period we’ve experienced significant rises in utility bills.
- Housing: up 6.6%. Driven by higher house prices, higher council taxes, and higher mortgage interest payments. These are excluded from the narrower CPI measure, which in part explains why CPI is lower than RPI. See here for the Office of National Statistics explanation for the differences in the measures.
- Housing Services: up 5.3%. Probably related to the stronger housing market. New migrant workers from the new EU members might put downward pressure on this component as they join the UK labour force?
- Food: up 4.5%. A major component of food prices is the cost of energy. Transportation costs are a big input, and fertilizer is often petrochemical based. Difficult weather conditions have also caused food prices to rise. Seasonal food price rises were extremely strong (+10.7%).
- Tobacco: up 4.1%

Components rising slower than the average
- Leisure Services: up 3.1%
- Personal Goods & Services: up 2.9%
- Alcoholic Drink: up 2.8%
- Catering: up 2.7%
- Travel Costs: up 1.5%. May be upward pressure on this as the result of significant rail fare increases in January. However, demand for air travel may fall as a result of recent travel chaos (terror alerts, fog, baggage problems, potential strike action in Q1), which may lead to some bargain flight deals.
- Household Goods: up 1.4%. The China effect – although less pronounced than in 2005 where we had deflation here.

Components currently in deflation
- Clothing and Footwear: down 0.4%. Again the impact of cheap production in the far east is a major factor, but deflation in this sector is much lower than it used to be. In 2002 this sector saw year on year price falls of 6%. Some very mixed signs from UK retailers over the Xmas period means we need to pay close attention to discounting here.
- Motoring Expenses: down 0.9%
- Leisure Goods: down 1.6%

If you’re looking for future bargains, the biggest acceleration in deflationary pressures appear to be in TVs (falling at around 20% pa) and cameras (down around 5% pa).

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