One week / one topic: Steamrollers

What happened?

Government bond yields remain on their relentless climb.

After hitting multi-year highs only a few weeks ago, yields across the US, UK, Germany and Japan have moved even higher.

In several cases, we are now looking at levels not seen for decades.

While the most-often cited underlying reason is inflation, a closer look reveals a more complex picture beyond the headlines.

Yes, higher energy prices continue to pressure inflation, leaving central banks in a difficult position.

However, if the problem is an energy shock, higher base rates do little to address the root cause... Yet everybody knows that everybody knows that policymakers cannot simply do nothing.

Meanwhile, US breakeven inflation rates have only risen modestly and almost entirely at the front end of the curve.

Two-year breakevens have indeed moved higher, reflecting the acute shock from higher energy prices – but five-, ten- and thirty-year measures remain relatively well-anchored.

In other words, investors appear concerned about inflation today, but not necessarily convinced that things will look materially different several years from now.

As a sense-check, we can compare the above for example with what’s going on in the UK – a country that has been struggling with stubborn and above-target inflation even more than the US.

The data here indeed tells a somewhat different story, as inflation expectations have risen more broadly across maturities.

In other words, investors – since UK inflation has been consistently above the target for many years now – are less willing to give policymakers the benefit of the doubt. (just ask Gilts)

What can we make of this, beyond the (never) obvious specific implications about the UK?

Does this tell us something significant about what markets are pricing in, or their degree of conviction?

Our observations

• Fundamentals: The recent rise in yields looks increasingly like a credibility story rather than a pure inflation story.

  The market is asking whether central banks can ultimately bring inflation back to target, not simply whether energy prices remain high next month.

• Price action: The spread between five-year and two-year breakeven rates sits close to recent lows for the UK, but not the US. (below)

  How much of this is due to market-specific characteristics is hard to measure, but it does point towards a different perception of where vulnerabilities actually lie.

• Investor beliefs: Markets appear willing to treat the Iran-related inflation shock as largely temporary in the US, but not in the UK.

  Frustratingly, this dynamic once again does not appear to be immediately wrong or overdone…

So what?

Looking through the noise, markets appear convinced that inflation might stay high for a while still, but not forever. (duh)

The US – despite repeated attempts to undo it – still enjoys a degree of credibility that keeps longer-term inflation expectations anchored.

Other developed countries enjoy much less of it, with the UK standing out in that regard as structural challenges remain unaddressed.

The real question, then, is not whether inflation is temporary… It is where investors still believe that it is.

At the margin, this matters in terms of looking out for potential opportunities to increase portfolio duration… without stepping in front of the proverbial steamroller.

Mood music: James Taylor – Steamroller Blues (live 1994)

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The information provided should not be considered a recommendation to purchase or sell any particular security.