Inflation expectations are rising - or is it just oil?

Anthony Doyle

Firetrail Investments

Investors' favourite word last year was “unprecedented," but this year “reflation” appears to be on everyone’s lips. For central bankers and investors, breakeven rates are an important measure of inflation expectations. Simply put, the breakeven rate is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.

Breakeven rates are far from perfect. They can be affected by liquidity, inflation risk premia, and the technical features of buying an inflation-linked asset. Given this, breakevens are actually a measure of inflation compensation, comprised of expectation and other factors.

Of late, investors have been pointing to rising breakeven rates as a sign that a reflationary macroeconomic environment is here, fuelled by the roll-out of vaccines and resumption of global trade. Central bankers are happy, as rising inflation expectations suggest an environment where workers may feel confident enough to push for higher wages, thereby avoiding a deflationary environment (a central bankers greatest fear) for now.

It is important to note that while breakevens are rising, they seem to be moving to the beat of a higher oil price. The high correlation between breakeven rates and oil prices is not a new phenomenon, but it has puzzled market participants and academics alike. 

A high correlation between oil prices makes sense in the short-term; why would changes in oil prices affect inflation five, 10, or 20 years from now? Some have suggested that whatever is moving the oil price could be having an impact on all other prices and wages, such as stronger economic growth. For me, that’s a pretty weak rationale, especially as breakevens are rising across multiple markets.

One thing that does appear to make sense though is given the very high correlation between breakevens and oil, for breakevens to move higher, the oil price will have to march higher from its current level of around USD60 a barrel.

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Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.

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Anthony Doyle
Head of Investment Strategy - Firetrail S3 Global Opportunities Fund
Firetrail Investments

Anthony Doyle is Head of Investment Strategy for the Firetrail S3 Global Opportunities Fund. His primary responsibilities include fundamental idea generation, portfolio analysis, and economic insights including currency and macroeconomic risk...

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