As 2022 draws to a close, the time has come to consider the lessons learnt during this exceptional year. Unsurprisingly, most of these relate to inflation.

For years, the inflation hedges held in diversified portfolios have been detrimental to their performance: this holds true for commodities and for exposure to inflation breakevens. Fixed income hedges against inflation (loosely referred to as “breakevens”) are generally achieved through two different products: inflation swaps and inflation-linked bonds whose duration exposure has been stripped out. Like other inflation hedges, their performance has been negative: around -1% per year since 2006, with a volatility of about 5% for a 10-year maturity exposure. That long-term performance seems unattractive, yet those who maintained their exposure in 2022 were able to mitigate losses: the year-to-date performance of a 10-year inflation swap is about +4.6% (to the end of October, in dollar terms).

Amid this inflation shock, which of these two ways to gain exposure to inflation (bonds or swaps) would we recommend? Based on several years’ experience and some additional research, we believe swaps make more sense and here is why.

 

The hidden duration effect

There are two well-known ways to be explicitly hedged against inflation in the fixed income world:

• Buying inflation-linked bonds and selling futures or sovereign bonds to hedge against their nominal yield duration.
• Zero-coupon inflation swaps.

The functioning of the latter is simple and amounts to exchanging a variable inflation rate for a fixed one, for a given nominal amount. The functioning of the former is trickier and usually less well understood. Inflation linkers can be complicated by duration hedging, resulting in a less intuitive situation. Their nominal value and the coupon are a function of inflation: when inflation rises, these values grow, but the duration of the inflation linker also increases.

These hedges are needed when inflation grows and surprises us on the upside, yet it is precisely that element of surprise that prevents us from actively managing the duration ex-ante. Figure 1 illustrates how the duration of these bonds varies as inflation increases. On a 10-year bond, a 1% inflation surprise increases duration by just 0.03 years – which is low – but on a 30-year bond, that duration increase reaches 0.15 years. A 2.5% rates variation, as happened this year, would lower the performance of inflation hedges by 7.5 bps or 37.5 bps respectively, which is not particularly desirable.

This is even more pertinent as inflation-linked bonds usually have high maturities, given they are used to help pension schemes hedge their inflation risk over the long term. It is important to note that this effect can be minimised by continuously adjusting the short duration leg of a synthetic breakeven to eliminate the additional duration effect. However, we see this as a drawback as it requires investors to be extremely vigilant on the progression of duration in their portfolios at a time when duration is already a higher risk factor than usual.

 

Figure 1: Estimated increases in the duration of inflation-linked bonds as a function of inflation surprises

Source: Bloomberg, LOIM

 

I know what you did last inflation shock

The duration effect may seem small but its impact during periods of inflation surprises can be material. Looking such episodes since 2006 – the period for which we have reliable performance data in dollar terms – and focusing in on the US, given this is where inflation surprises have been most pronounced among developed markets, we have created a list of four distinct inflation periods:

• the 2007 oil shock,
• the 2010-2011 recovery leading to another oil shock,
• the 2016-2017 inflation surge that prompted the Federal Reserve (Fed) to hike rates,
• The 2021-2022 inflation shock we are currently experiencing.

For each period, figure 2 compares the evolution between inflation-linked bond (ex-duration) and inflation swap exposure (both based on a 10-year tenor). Across three of these four inflation periods, the swap exposure would have delivered a higher return: 2007, 2016-2017 and 2021-2022. Only in 2010-2011 would have we seen inflation-linked bonds do better. What makes that period exceptional is that the Fed was not hiking rates and was letting inflation run through the US economy as the inflation shock was only temporary in nature. In the rest of these examples, the Fed hiked rates to bring inflation down, with differing levels of aggression, creating the aforementioned hidden duration effect.

Inflation-linked bonds often fail to protect investors when investors need them the most. This seems to happen precisely because central banks need to fight off inflation pressures by hiking rates. 2010-2011 was a singularity, as hiking rates during inflation shocks is the norm, not the exception. 2022 is the perfect illustration of that – the performance gap between both solutions widened right after the Fed signalled its intent to hike rates.

 

Figure 2: Rebased performance of inflation linked bonds (ex-duration) and inflation swaps over the past four inflation shock periods

Source: Bloomberg, LOIM

 

Simply put, 2022 has delivered an important lesson in terms of inflation hedging: favour inflation swaps over the imprecision of inflation-linkers, which can unexpectedly be weighed on by duration.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

• Worldwide growth is lower than it was six months ago. The US signal has further extended its decline this week – it has now reached 40%, which is 5% below the recession threshold.
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere. This week, Eurozone pressures have even increased from our metrics, suggesting the European Central Bank will remain hawkish.
• Central banks’ hawkish stance should continue. However, during recent weeks our monetary policy indicator has started to decline in the US as inflation pressures are easing, as expected.  

 

World growth nowcaster: long-term (left) and recent evolution (right)

 

World inflation nowcaster: long-term (left) and recent evolution (right)

 

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).