Convulsing bond markets mean different things to different people. If you run a government, it is plainly bad that government-borrowing costs are shooting up—as they are across the world. The yield on Japan’s 30-year debt has shot above 4%, its highest ever; America’s has topped 5%; Britain’s is chugging fitfully towards 6%. Since mortgage rates tend to move in line with these yields, anyone looking for a new one will also feel the pinch. For bond traders, in contrast, the past few weeks have been quite the thrill. A decade ago near-zero interest rates seemed to have permanently shoved their market into the deep freeze. Now it is red hot.
It is not hard to see why. Inflation and yawning government deficits have worried investors for years, and the Iran war is making both problems worse. Bank of America conducts a monthly survey of global fund managers; in the latest, 40% of respondents said an inflationary wave was the biggest tail risk for markets. Despite this (or in explanation of it), 78% expected America’s Federal Reserve to either cut rates or leave them unchanged over the next year. They have acted accordingly, slashing holdings of cash and bonds, while raising their equity allocations by more than in any other month of the survey’s 25-year history. This is just what you might do if you think money is too loose.
Given all this, it may seem puzzling that one market hasn’t moved more. Inflation-linked government bonds (“linkers”, or “TIPs” in America) offer the ultimate protection against investors’ fears: payments that are guaranteed to rise by the same amount as consumer prices. They therefore offer real yields, as opposed to the nominal ones on ordinary bonds, at which inflation nibbles away. The nominal yield minus the real one—for, say, ten-year American Treasuries—is widely thought of as the average inflation rate investors expect over the bonds’ remaining life.
Fed officials might draw comfort from this ten-year “break-even”. At 2.5% it is roughly in line with their target and only a few tenths of a percentage point higher than it was at the start of this year. But that would be a mistake. The TIPs market is not subdued because investors are relaxed about inflation. Rather, it offers a cautionary tale about the limits of market efficiency—and therefore on using prices to forecast the future.
As Exhibit A, consider how poorly TIPs-derived break-evens have sometimes performed at this in the past. During the panic that accompanied the first covid-19 lockdowns, in 2020, America’s ten-year break-even hit 0.5% and the two-year equivalent fell to -1%. In fact, barely a year later, the biggest inflationary surge in decades took off, and in 2022 the annual rate peaked above 9%.
No trader has perfect foresight in the teeth of a crisis. Exhibit B, however, is that even one who did would struggle to act on it when it comes to inflation break-evens. Compared with the market for normal Treasuries, that for TIPs is small, illiquid and lacking in arbitrage opportunities. They account for just 7% of American government bonds and are favourites of pension schemes, which hold them in order to guarantee retirement payouts and so might not sell at any price. In theory, arbitrageurs should smooth out any distortions this causes using derivative contracts. In practice, trading inflation derivatives throws up so many complications that opportunistic traders often cannot find a broker willing to take them on.
Exhibit C is the unique function of ordinary Treasury bonds. Investors do not only, or even mainly, use them to bet on the future path of interest rates and inflation, but as a safe harbour when other markets are turbulent. They also trust that, during a big stockmarket crash, interest rates would fall and Treasury prices would rise, cushioning their losses. Erratic policymaking in America has tested both beliefs recently. But not to destruction: people still hold Treasuries with an eagerness that does not apply to TIPs. So Treasury yields are tugged down and those of TIPs are not, meaning the break-even—the gap between the two—is depressed.
The effect is especially strong during a panic, when the safety of Treasuries is most appealing. Almost certainly, this helps explain why break-evens fell so low in 2020. If you want to guarantee your purchasing power no matter how far consumer prices rise, linkers are just the thing. If you want to know how much investors fear inflation, you may need to look elsewhere.
