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Is rising inflation looming?

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GoSeigen
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Re: Is rising inflation looming?

#441175

Postby GoSeigen » September 10th, 2021, 9:18 am

AWOL wrote:Personally I think that insuring against inflation is too expensive to bother with as the markets have priced it in as soon as it was seen as a potential issue. On the other hand Gold doesn't look too elevated though but how can one know it's intrinsic value!


Can you give examples. I can't see inflation priced in in any way shape or form.

GS

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Re: Is rising inflation looming?

#441189

Postby AWOL » September 10th, 2021, 10:01 am

GoSeigen wrote:
AWOL wrote:Personally I think that insuring against inflation is too expensive to bother with as the markets have priced it in as soon as it was seen as a potential issue. On the other hand Gold doesn't look too elevated though but how can one know it's intrinsic value!


Can you give examples. I can't see inflation priced in in any way shape or form.

GS


By any measure Index Linked Gilts are extremely expensive which is the pricing in that always happens when people anticipate risk making the act of insuring against it prohibitive for those who didn't take out the insurance in advance. Index linked gilts are delivering negative real yields and if held to maturity significant capital loss. Here's a handy table showing money yield assuming 3% inflation but pick your value and then consider how duration will effect returns.

https://www.fixedincomeinvestor.co.uk/x ... oupid=3530

GoSeigen
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Re: Is rising inflation looming?

#441211

Postby GoSeigen » September 10th, 2021, 10:57 am

AWOL wrote:
GoSeigen wrote:
AWOL wrote:Personally I think that insuring against inflation is too expensive to bother with as the markets have priced it in as soon as it was seen as a potential issue. On the other hand Gold doesn't look too elevated though but how can one know it's intrinsic value!


Can you give examples. I can't see inflation priced in in any way shape or form.

GS


By any measure Index Linked Gilts are extremely expensive which is the pricing in that always happens when people anticipate risk making the act of insuring against it prohibitive for those who didn't take out the insurance in advance. Index linked gilts are delivering negative real yields and if held to maturity significant capital loss. Here's a handy table showing money yield assuming 3% inflation but pick your value and then consider how duration will effect returns.

https://www.fixedincomeinvestor.co.uk/x ... oupid=3530


If this is the prime exhibit, then it's really a misunderstanding of ILGs. ILG's will protect against inflation no matter what price people pay for them, so you cannot read anything into the price in terms of inflation protection.

But even more important: what is actually being protected when you buy ILGs? It is the real yield and as AWOL has noted, that is negative. So even with the inflation protection you will lose money holding ILGs (in real terms). What the high price shows is not the investors value inflation protection but actually that they are terrified of deflation!! Even ILGs are okay in a deflation scenario because they may perform better than other assets -- in fact this is precisely what we have seen over the past ten years.

So I stick to my view that no inflation being priced in whatsoever. One only has to look at fixed gilts to see that: if there were even inflation of 2% over an appreciable term, not only would you lose money in real terms, but unless the bond market fails completely, you will lose money on your long gilts too as their yield returns to something above 2%.

I agree about Gold: very difficult to interpret its pricing -- though looking at it relative to other assets helps. As an example, take a look at the S&P to Gold ratio.


GS

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Re: Is rising inflation looming?

#441258

Postby dealtn » September 10th, 2021, 1:36 pm

GoSeigen wrote:
So I stick to my view that no inflation being priced in whatsoever.


So you think the Gilt breakeven curve is currently negative, and the same for the inflation swaps curve?

GoSeigen
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Re: Is rising inflation looming?

#441265

Postby GoSeigen » September 10th, 2021, 2:07 pm

dealtn wrote:
GoSeigen wrote:
So I stick to my view that no inflation being priced in whatsoever.


So you think the Gilt breakeven curve is currently negative, and the same for the inflation swaps curve?


Well it's true that break-evens have tracked Central bank (approx 2%) inflation targets pretty well for some 20 years. If inflation sitting between 1% and 3% is all that AWOL was concerned about then I have misunderstood. But I'd want break-evens to rise a further 100bp before they start to get interesting -- to a level they haven't seen since 1996.


GS

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Re: Is rising inflation looming?

#441266

Postby AWOL » September 10th, 2021, 2:10 pm

GoSeigen wrote:[
So I stick to my view that no inflation being priced in whatsoever. One only has to look at fixed gilts to see that: if there were even inflation of 2% over an appreciable term, not only would you lose money in real terms, but unless the bond market fails completely, you will lose money on your long gilts too as their yield returns to something above 2%.


I personally have long held the opinion that linkers are mispriced. There are multiple reasons for this but the main one is institutional purchase of them in an attempt to liability match. My defined benefit pension is 50% invested in linkers and it's not alone. The problem is that there are £1.8bn of assets managed by UK defined benefit pension schemes dwarfing the supply of linkers and driving ludicrous valuations. The trustees think that they are doing the right thing as their liabilities are indexed however at current pricing that other half of the portfolio is going to have to work very hard at a time when equities are richly valued. I don't know to what extent they are compelled by legislation to make this assessment of how to best meet their liabilities but it seams dubious to me.

Anecdotally, I keep hearing private investors tell me how they have wisely allocated to index-linked gilts as they are sure inflation is coming however I think their purchases will be just noise in the ocean of pension fund purchases and wont have a strong effect on valuations. I expect they are most likely to be disappointed, unless we get deflation which seams unlikely.

When even Ruffer only has a stub of linkers left one has to question the value remaining in them.

Surely if deflation was being prepared for then regular gilts would offer superior real returns.

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Re: Is rising inflation looming?

#441268

Postby dealtn » September 10th, 2021, 2:13 pm

GoSeigen wrote:
dealtn wrote:
GoSeigen wrote:
So I stick to my view that no inflation being priced in whatsoever.


So you think the Gilt breakeven curve is currently negative, and the same for the inflation swaps curve?


Well it's true that break-evens have tracked Central bank (approx 2%) inflation targets pretty well for some 20 years. If inflation sitting between 1% and 3% is all that AWOL was concerned about then I have misunderstood. But I'd want break-evens to rise a further 100bp before they start to get interesting -- to a level they haven't seen since 1996.


GS

So your "no inflation being priced in whatsoever" is now inflation is being priced at approximately the Central Bank's target range, a level you don't find attractive enough to invest at?

Why make it so difficult for others to know what you mean if you believe something but say something else? If your comment had been along those lines initially it wouldn't have been worthy of commenting on.

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Re: Is rising inflation looming?

#441342

Postby anon155742 » September 10th, 2021, 7:12 pm

anon155742 wrote:
dealtn wrote:
anon155742 wrote:GDP per capita for 2020 is still at 2004 levels ...

https://data.worldbank.org/indicator/NY ... cations=GB


Probably best to make that statement in Local Currency Unit (although that diminishes your argument).

https://data.worldbank.org/indicator/NY ... cations=GB

anon155742 wrote:
...and probably undercounts population.



Do you think the population count was accurate in 2004, and the imbetween years too?
dealtn wrote:
anon155742 wrote:Tell me, why would you not use a constant LCU? Constant ones are more appropriate since they actually take inflation into account.



?

My suggestion was a constant one! Precisely as you suggest, "constant LCU".


No it was not. Click your own link again and you will see the title: GDP per capita (current LCU).

Constant LCU shows that we are, like I said in my initial post, back to our 2004 levels of GDP per capita.

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Re: Is rising inflation looming?

#441429

Postby TheMotorcycleBoy » September 11th, 2021, 11:20 am

dealtn wrote:
GoSeigen wrote:
So I stick to my view that no inflation being priced in whatsoever.


So you think the Gilt breakeven curve is currently negative, and the same for the inflation swaps curve?

Hi dealtn

What exactly is the gilt breakeven curve?

Is it related to this?
http://www.inflation-linked.com/breakeven.html
https://www.macronomics.no/fixed-income ... ven-rates/

thanks Matt

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Re: Is rising inflation looming?

#441466

Postby GoSeigen » September 11th, 2021, 1:55 pm

dealtn wrote:
GoSeigen wrote:
dealtn wrote:
So you think the Gilt breakeven curve is currently negative, and the same for the inflation swaps curve?


Well it's true that break-evens have tracked Central bank (approx 2%) inflation targets pretty well for some 20 years. If inflation sitting between 1% and 3% is all that AWOL was concerned about then I have misunderstood. But I'd want break-evens to rise a further 100bp before they start to get interesting -- to a level they haven't seen since 1996.


GS

So your "no inflation being priced in whatsoever" is now inflation is being priced at approximately the Central Bank's target range, a level you don't find attractive enough to invest at?


Where did I say that?

GS

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Re: Is rising inflation looming?

#441476

Postby TheMotorcycleBoy » September 11th, 2021, 3:00 pm

Ok, I got off my ass and did some reading/research. Conventional gilt yield - Linker yield = BE inflation.

Conventional

Image

Linker

Image

so we have 0.385 - 1.071 = -0.686%. Hence BE inflation is negative. But what does this number actually mean? It looks it means that as long inflation is greater than -0.686% then the linker will outperform the regular gilt. Does it not also mean that the market quite drastically doesn't expect significant inflation over the next 10 year period, since its priced the linker a lot lower than the gilt, so folk aren't thinking that they need to spend money on inflation hedging?

Matt

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Re: Is rising inflation looming?

#441478

Postby TheMotorcycleBoy » September 11th, 2021, 3:07 pm

Ahh. I just looked at T40 and ILG 2040. They tell a different story.

https://www.hl.co.uk/shares/shares-sear ... 25-il-2040
https://www.hl.co.uk/shares/shares-sear ... 4,1-4-2040

i.e. 2.715 - 0.351 = 2.364

I'm guessing that one needs to look at much longer dated gilts i.e. about 20 or so of maturity to get a clearer view of the markets inflation expectations.

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Re: Is rising inflation looming?

#441572

Postby dealtn » September 12th, 2021, 9:33 am

TheMotorcycleBoy wrote:
What exactly is the gilt breakeven curve?



By comparing the nominal yield and the real yield of conventional gilts and index linked gilts you get an approximate market based inflation rate. It's approximate for a number of reasons. Firstly it is unusual to get exact matches of redemption dates on the gilts, so the simply derived difference lacks accuracy. Secondly you need to adjust for the credit curve of the issuer, which is usually negligible, but even for the UK government is non-zero. Thirdly the "yield" on index linked gilts does have some assumptions in its calculation (which aren't strictly speaking comparable between old style 8 month lagged linkers and new style 3 month lagged linked linkers). Fourthly there maybe specific market distortions which affect one type of gilt differently to others. (For instance there is pressured demand to purchase linkers at some parts of the curve more than conventionals due to "pensions" rules; QE applies to conventionals and not linkers etc.)

In general the distortions, whilst real (no pun), remain fairly constant, especially over short time frames, so a breakeven analysis can be useful to approximate inflation expectations, and changes in them.

Importantly though, if you want to look at inflation expectations for future time periods (rather than the average over the time up to that period) which is more useful), you need to analyse the future inflation curve, not the breakeven curve itself.

Hope that helps.

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Re: Is rising inflation looming?

#441578

Postby GoSeigen » September 12th, 2021, 10:09 am

TheMotorcycleBoy wrote:so we have 0.385 - 1.071 = -0.686%. Hence BE inflation is negative. But what does this number actually mean? It looks it means that as long inflation is greater than -0.686% then the linker will outperform the regular gilt. Does it not also mean that the market quite drastically doesn't expect significant inflation over the next 10 year period, since its priced the linker a lot lower than the gilt, so folk aren't thinking that they need to spend money on inflation hedging?

Matt


You're using the running yield which is meaningless. Use the YTM instead.

GS

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Re: Is rising inflation looming?

#441581

Postby dealtn » September 12th, 2021, 10:35 am

GoSeigen wrote:
TheMotorcycleBoy wrote:so we have 0.385 - 1.071 = -0.686%. Hence BE inflation is negative. But what does this number actually mean? It looks it means that as long inflation is greater than -0.686% then the linker will outperform the regular gilt. Does it not also mean that the market quite drastically doesn't expect significant inflation over the next 10 year period, since its priced the linker a lot lower than the gilt, so folk aren't thinking that they need to spend money on inflation hedging?

Matt


You're using the running yield which is meaningless. Use the YTM instead.

GS


Better still don't use old style 8 month linkers full stop.

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Re: Is rising inflation looming?

#441614

Postby anon155742 » September 12th, 2021, 1:18 pm

Dealtn, you havent said anything in reply about the GDP per capita levels being back to 2004 levels.

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Re: Is rising inflation looming?

#441643

Postby TheMotorcycleBoy » September 12th, 2021, 2:33 pm

dealtn wrote:
GoSeigen wrote:
TheMotorcycleBoy wrote:so we have 0.385 - 1.071 = -0.686%. Hence BE inflation is negative. But what does this number actually mean? It looks it means that as long inflation is greater than -0.686% then the linker will outperform the regular gilt. Does it not also mean that the market quite drastically doesn't expect significant inflation over the next 10 year period, since its priced the linker a lot lower than the gilt, so folk aren't thinking that they need to spend money on inflation hedging?

Matt


You're using the running yield which is meaningless. Use the YTM instead.

GS


Better still don't use old style 8 month linkers full stop.

Hello again, people.

I attempted to research yield curves and BE inflation some more by reading more words from the BoEs sites, downloading some data, having a few guesses, and then graphing some figures. I briefly wrote things up over here so as not to derail this one too much. Would appreciate your comments, criticism etc.

thanks Matt

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Re: Is rising inflation looming?

#442447

Postby dealtn » September 15th, 2021, 12:06 pm

A noticeable rise in reported inflation day, and the trigger for the Bank of England to explain its thinking.

https://www.bbc.co.uk/news/business-58563417

Whilst the rate isn't that far above the top of the Bank's target, nor significantly high by historical standards, it does mark the steepest monthly increase since comparable records began in 1997.

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Re: Is rising inflation looming?

#442536

Postby TheMotorcycleBoy » September 15th, 2021, 4:08 pm

dealtn wrote:A noticeable rise in reported inflation day, and the trigger for the Bank of England to explain its thinking.

https://www.bbc.co.uk/news/business-58563417

Whilst the rate isn't that far above the top of the Bank's target, nor significantly high by historical standards, it does mark the steepest monthly increase since comparable records began in 1997.

So that's (3.2%) about 0.6% less than the value predicted by Gilts vs ILGs (3.8ish%).

Help me out and show how me to derive inflation forecasts from the inflation swap curves. ;)

Matt

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Re: Is rising inflation looming?

#442603

Postby dealtn » September 15th, 2021, 7:01 pm

TheMotorcycleBoy wrote:
dealtn wrote:A noticeable rise in reported inflation day, and the trigger for the Bank of England to explain its thinking.

https://www.bbc.co.uk/news/business-58563417

Whilst the rate isn't that far above the top of the Bank's target, nor significantly high by historical standards, it does mark the steepest monthly increase since comparable records began in 1997.

So that's (3.2%) about 0.6% less than the value predicted by Gilts vs ILGs (3.8ish%).

Help me out and show how me to derive inflation forecasts from the inflation swap curves. ;)

Matt


Firstly the Index Linked Gilts all reference RPI, not CPI. RPI is 4.8% according to todays announcement.

Secondly the breakeven calculation from the Gilts market is complicated. I didn't read your BofE numbers from the other day but I think they were 3.5%ish across the curve. What's important to note though is this is a "spot" curve not a "forward" curve so it isn't intuitively obvious what the predicted rate of inflation is.

In simple terms if 1 year "spot" inflation is priced at 3.5% and 2 year inflation is also priced at 3.5%, then the 1 year inflation rate in a years time is also priced at 3.5%. The 2 year rate is the average, and since we know the 1 year rate is also 3.5%, then the second year must also be 3.5%.

Were spot prices such that 1 year was 2% and 2 year was 3% then we can infer that (approximately) the 1 year rate starting in 1 years time is 4% (since 1 year at 2% followed by 1 year at 4% gives a 2 year average of 3%). This is called "bootstrapping" where you can construct the forward implied rate (be that inflation, or interest, or FX etc.) from all known spot prices along a curve to derive successive unknown future points in between.

In the example above we knew the 1 year and 2 year rates to get the unknown 1 year rate starting in 1 years time. With a 3 year spot rate (and a 1 year and 2 year and the 1 year in 1 years time rate) we can calculate the 1 year rate starting in 2 years time. With a 4 year (knowing the 1 year, 2 year, 3 year, 1 year 1 year forward, 1 year 2 years forward) you can know calculate the 1 year 3 years forward rate etc.

In practice you will have a pricing model more complicated than this and can derive all sorts of more complicated future rates of multiple periods, and create zero coupon real and nominal interest rates for any future date to use to discount any predicted cashflows back to their net present values (NPV) etc.

I hope I didn't lose you.


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