Key Points:
- Governments around the world are using massive stimulus to battle the economic effects of COVID-19.
- Investors and market participants are increasingly concerned about the impact of inflation on their portfolios.
- The inflation breakeven rate gauges the market’s inflation outlook.
- The Local Inflation factor captures the market’s outlook for inflation and provides a hedge against inflationary risk.
- The Local Inflation factor has a 97% correlation with shifts in breakeven inflation.
- The core macro factors of Equity, Credit, and Commodities also have positive correlations with breakeven inflation changes.
- Investors can use factor analysis to measure exposure to Local Inflation and core macro factors.
- Allocating to Treasury Inflation-Protected Securities (TIPS) can increase a portfolio’s inflation sensitivity.
- Investors may also consider other inflation hedges, such as gold and natural resource equities.
- No one knows the future path of inflation, but investors can take steps to manage their inflation risk.
Governments around the world have implemented significant stimulus measures to combat the economic impact of COVID-19. As economies reopen, there is a growing concern about rising consumer prices and the potential effects of inflation on portfolios. In order to understand how shifting inflation expectations may affect portfolios, it is important to consider the Local Inflation factor and breakeven inflation.
The inflation breakeven rate measures the market’s outlook for inflation by comparing the yield of a nominal bond with that of an inflation-linked bond with the same maturity. This rate provides an approximation of what market participants expect inflation, as measured by the Consumer Price Index, to be over the next 10 years.
During the market crash earlier this year due to COVID-19, inflation breakevens dropped significantly, reflecting a decline in inflation expectations. However, other factors such as liquidity differences between nominal and inflation-linked bonds may have also impacted breakevens.
In recent months, breakevens have been on the rise due to the substantial stimulus measures implemented in response to the pandemic. This upward trend in inflation expectations highlights the concern over rising inflation.
To manage inflation risk, investors can consider the Local Inflation factor. This factor, in its raw form, attempts to capture the market’s outlook for inflation and provide a hedge against inflationary risk. The raw Local Inflation factor is calculated as the total return difference between an inflation-linked bond index and a Treasury index.
Data shows that the raw Local Inflation factor has exhibited a 97% correlation with shifts in breakeven inflation over the past five years. However, in practice, it is important to consider the less liquid Local Inflation factor in relation to the more liquid core macro factors, such as Equity, Credit, and Commodities, which have positive correlations with breakeven inflation changes.
To effectively manage inflation risks in a fixed-income portfolio, investors can use factor analysis tools like Venn. By analyzing exposures to the Local Inflation factor and core macro factors, investors can assess their portfolios’ sensitivity to changes in inflation expectations.
For example, a fixed-income portfolio manager can use Venn to measure the portfolio’s exposure to the Bloomberg Barclays US 10 Year Breakeven Inflation Index. A beta of 0.05 indicates a positive correlation between the portfolio and changing inflation expectations. In other words, if breakeven inflation increases by 10 basis points, the portfolio is forecasted to return 4 basis points.
To further hedge against inflation risk, the portfolio manager can consider reallocating to Treasury Inflation-Protected Securities (TIPS) and reduce exposure to core fixed income. This would increase the portfolio’s sensitivity to inflation expectations and improve its inflation hedging capabilities.
By testing different portfolio allocations, including other inflation hedges like gold and natural resource equities, investors can determine the best strategy to increase their portfolios’ inflation sensitivity.
It is important to note that the future path of inflation is uncertain. However, by taking steps to measure and manage inflation risk, investors can gain a better understanding of their portfolio’s exposure and take appropriate action if needed.
1. In theory, the yield difference between nominal and inflation-linked bonds includes factors beyond expected inflation, such as an inflation risk premium. Liquidity differences and short-term investor demand can also impact pricing.
2. The beta conversion from return space to yield change space is calculated by multiplying the beta by the duration. Assuming a duration of 8 for the TIPS and Treasuries indices, a 10 basis point increase in inflation expectations would result in a 10 basis point decrease in real yields, leading to an 80 basis point return for TIPS. Multiplying this by a beta of 0.05, the portfolio is expected to increase by 4 basis points.
