Quantitative Easing and index-linked gilts – a little less information

Central bankers passionately love inflation-linked bonds.  Firstly, they keep governments honest by discouraging them from generating inflation in order to reduce their debts, and secondly they provide real “put your money where your mouth is” information as to where the financial markets think inflation is heading.  Unfortunately, the Bank of England’s new QE regime makes the information derived from index-linked gilts useless – and in a perverse way too.

Just at the time when everybody is worrying that QE is the first step on the road to the issuance of Zimbabwe style One Hundred Trillion Dollar notes (I have one in front of me as I type, the watermark is a picture of a buffalo’s backside), we’ve seen a collapse in the expected future level of inflation in the UK, according to the gilt market.  In February, before the Bank’s QE announcement, the 10 year breakeven inflation rate was just below 2.5%.  It subsequently halved to 1.25%.  In other words the bond market expected half the level of inflation over the next ten years than it had before the Bank turned on the printing presses.  As I said, perverse. 

The problem is that the Bank’s QE programme only targets ordinary gilts (£75 billion of them).  Index linked gilts are excluded (for liquidity reasons) and have therefore missed out on some of this big rally.  Conventional gilt yields have therefore fallen further, and dragged down the breakeven inflation rate (the difference between nominal (conventional) and real (index linked) yields).  This is probably an unintended consequence – but in so far as this “information” is used by wage setters and policy makers, might it in itself prove deflationary? 

Since the height of the QE driven conventional market rally, linkers have caught up a little (the implied inflation rate has risen to 1.75%) – but the fact remains, if QE excludes linkers, then the information contained within their prices will become less valuable.  Perhaps this is why the Bank has recently placed more emphasis on survey data (the Bank of England/GfK NOP Inflation Attitudes survey) when they talk about future inflation expectations?

Discuss Article

  1. Mark Holdt says:

    TIPS can underperform even if inflation turns out to be greater than was priced in the breakevens

    I believe that investment decisions for Inflation linked securities are generally based purely (and incorrectly) on the outlook for inflation. Fund managers and investors alike, who generally do not invest until maturity but manage against a benchmark, base their investment decision on the difference between their own inflation expectations and inflation rates. This may be the correct decision for buy-and-hold investors, but may be disappointing for money managers who may become disenchanted when they see inflation expectations rising (as they correctly forecast) yet see TIPS underperforming.

    In fact TIPs prices will stay unaffected with inflation changes, if real rates are held artificially constant. That is although investors can expect higher inflation-adjusted coupons, a higher discount rate will offset any of these benefits. On the other hand if inflation expectations increase, complimented by a decrease in real rates (i.e a stagflationary scenario), then TIPS prices will increase. Importantly a shorter-term investor should base his decision on his outlook for inflation and real rates (growth rates) relative to those of the market. Investors who use TIPS merely as a bet on increased inflation may become disenchanted if market-to-market movements during inflationary surges do not lead to increases in TIPS prices.

    With real yields for US TIPS now below 2% again, I think M&G should throw out those TIPS; otherwise you may also become disenchanted.





    Posted on: 25/03/09 | 12:00 am

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