May 28, 2020

What does the bond market tell us about inflation risk?

The fiscal response to the crisis is pushing public debt to very high levels. Concomittantly, central banks purchase massive amounts of public debt to keep interest rates low. In other words, central banks are effectively financing governments by creating money (I explain here how this works in practice). Historically, government financing by money creation led to dramatic episodes of hyperinflation as is currently happening in Venezuela. Is there inflation risk today in Europe?

We can learn a great deal about inflation risk from the bond market. A first hint is the level of interest rates. When inflation expectations increase, interest rates rise to compensate for the fact that the purchasing power of money is expected to decline. For instance, if you aim for a return adjusted for inflation of 2% and inflation is 1%, you need an interest rate of 3%. 2% if called the real interest rate and 3% is called the nominal interest rate. They are linked by the relation:

Real interest rate = Nominal interest rate – Inflation rate

When people talk about interest rates without specifying which rate they refer to, they mean nominal rates.

The 10-year nominal rate on French government bonds is currently minus 0.1% per year (yes, it is negative!) Therefore, unless the real rate is highly negative, it means that expected inflation is low. But how can we be sure the real rate is not highly negative?

Here come inflation-indexed bonds whose annual coupon payment is indexed on inflation: the coupon rate is a fixed rate plus realized inflation. At current market conditions, a French 10-year inflation-indexed bond promises a return of minus 0.7% per year plus inflation. Inflation-indexed bonds are great because they are informative about expected inflation. Since the yield of a nominal bond is minus 0.1% and the yield on an inflation-indexed bond is minus 0.7% plus inflation, we can conclude that:

Conclusion: Expected inflation = (– 0.1%) – (– 0.7%) = 0.6% per year (yes, negative rates are a pain!) Market participants therefore expect a low rate of inflation, even below the ECB's inflation target of 2%.

Quiz: The calculation of expected inflation equal to 0.6% per year overlooks a fundamental principle of finance and is potentially incorrect. Can you see why? Answer here

Source: Data on French inflation-indexed bonds are from Agence France Trésor.

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