Bonds: Threats from higher core inflation and inflation carry – BNPP

Laurence Mutkin, Research Analyst at BNP Paribas, suggests that higher core inflation prospects and positive seasonal inflation carry are a powerful combination, which will support breakeven inflation, and so weigh on nominal bonds in the coming two to three months.

Key Quotes

“Core inflation, having surprised on the upside, will rise further, according to our economists’ expectations. Their reasons are:

• In the US, effectively at full employment, we expect core services to fuel the rise, though recently core goods’ strength has been surprising. 
• In the euro area, despite no immediate wage pressures, core inflation will be driven up by higher headline inflation (raising expectations); reduced slack; a slowing of some countries’ competitiveness adjustment; and the more favourable global outlook. 
• In Japan and the UK, currency depreciation is responsible for core inflation’s expected surge in 2017, but even in 2018 we forecast stabilisation well above recent years’ levels.” 

“Stronger core inflation will dampen markets’ fears that inflation will fade, and will support expectations of less-loose monetary policy, raising yields.”

“Now is the season for positive inflation carry, providing investors with a positive carry way of shorting nominal bonds. In the US and euro area, buying 5year inflation should pay about 11bp and 40bp respectively for three months. In the UK, real yields are already too low: the inflation curve is a better trade.”