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Authorities may waken inflation 'genie'.

Byline: ANDREW MILLER

CLIENTS we speak to are increasingly concerned about inflation. In particular, many fear that the aggressive monetary and fiscal policy response to the financial and economic crisis will lead to significantly higher inflation at some stage in the future; indeed, some suspect that governments are keen to engineer higher inflation so as to reduce the real cost of servicing the large debt piles they are currently building up.

We do not subscribe to the more extreme conspiracy theories on this issue, but do think quantitative easing and aggressive fiscal stimulus have the potential to push inflation significantly higher, and hence pose a huge potential threat to bond markets.

It is highly plausible that, in their bid to get their financial sectors back to health and restore their economies back to growth, authorities stimulate demand beyond their economies' potential output levels and awaken the inflation 'genie'.

For many investors, this would be a problem they would like to have, as risky assets, such as equities, would rebound strongly if we were to find ourselves in a position where the economy was pushing beyond full employment.

However, historically, the link between the growth in money creation and inflation has held only in the longer term; this leads us to suspect this threat to inflation may only emerge in a few years' time.

The more immediate threat, in our opinion, lies in a rebound in headline inflation due to higher commodity prices.

Last week, the inflation numbers in the UK surprised significantly on the upside; the US also reported higher-than-expected CPI figures.

The important point to recognise is that, across the G7, core inflation has dropped very little even as the world economy has headed in to recession; the decline in headline inflation rates practically everywhere is due to the decline in commodity prices, and oil in particular. However, as commodities rebound, it seems likely that the headline rate of inflation will move higher once again.

It would appear that bond markets are pretty complacent about this risk.

In particular, the spreads between the real yield on short-maturity inflation bonds and nominal bonds (called the breakeven, which gives one an indication of what the market's inflation expectations are) are still pricing very low inflation over the next few years in both the US and Europe.

These breakevens may not reflect the market's "true" inflation expectations, as the stresses in the financial system have led to forced selling of inflation bonds, as well as a large risk and liquidity premium for government bonds.

Nonetheless, the breakeven spread is still the cost one pays to insure against upside inflation risk, and at present we think that this insurance is very cheap.

One way we illustrate this idea is by calculating the nominal yield to maturity we expect on these bonds, given our inflation forecasts.

We find that in the US, UK and euro area markets, inflation bonds are expected to deliver significantly higher yields than similar maturity nominal government bonds.

With cash rates practically at zero, default risk making corporate bonds an unpalatable choice to many investors, and inflation risks increasingly shifting to the upside, we think short-dated inflation bonds are a very attractive option for investors looking to take little risk in their portfolios.

The case for index-linked gilts is further strengthened by their favourable tax treatment.

Andrew Miller is regional office head of Barclays Wealth
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Publication:The Journal (Newcastle, England)
Date:Apr 1, 2009
Words:565
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