Inflation in Ireland in the Recent Past & Causes

We saw spot prices of gas and heating oil increase dramatically recently but we can also see that they fell dramatically in 2020.

What this means is that the percentage increase in energy prices that we see today, year on year, is due to their calculation from a low base. Prior to the invasion of Ukraine, the ECB commented on the temporary nature of these energy ‘base effects’ and was projecting that this effect on price inflation in the Euro area would be gone by early 2022.

Clearly that hasn’t turned out to be the case.

Source: European Central Bank, Economic Bulletin 5, 2021

How Can We Protect or ‘Hedge’ Against Inflation?

We can see that in the recent past, short term cash deposits (as measured by the 6-month Euribor) have done a reasonable job of keeping up with inflation.

This has also tended to be true over the long-term as the data from 1955 in the UK clearly illustrates.

Source: includes composite data from multiple sources including Office for National Statistics in the UK

From this, we can conclude that short-term fixed interest has, historically at least, been a reasonably good hedge against inflation, and we see a similar picture in the USA since the 1920s.

We can also see that slightly longer-term bonds, 5-Year Treasury Notes in this example, have consistently offered a premium return.

A consideration that investors have been grappling with for some time now is the inverse correlation between interest rates and bond prices. Simply put, when interest rates go up, Bond prices absolutely will go down.

In the recent past we learnt to live with the idea that trillions of government bonds were trading at negative yields and even today, some savers are still being charged for their cash deposits.

But while this may strike many as unnatural, it is not unprecedented. In the Great Inflation of the 1970s real interest rates were extremely low or negative across much of the developed world.

Again, if we look to history, we can get a sense of how risky it is to hold Fixed Interest Bonds when interest rates increase.

GraphofSemi-annualreturnsof5-yearUSTreasuryNotes1926to2018

Source: Ibbotson & Associates

We can see from the graph above that whilst there are periods of negative semi-annual returns, historically at least these have been both brief and relatively shallow.

Source: FE

Putting the first six months of 2022 into historical context it would seem to have been the worst in recorded history for the bond market.

The Year-to-date return for the 5-year US Treasury note, generally seen as one of the safest investments on the planet is, at the time of writing, down 7.87%.

Source: FV00 | 5-Year U.S. Treasury Note Continuous Contract Overview | MarketWatch

Wherever you look around the world without exception investors in bonds are down this year with, as would be expected, US Longer Term bonds down over 23% Year to date in local currency terms.

Source: Wall Street Journ

Inflation-Linked Bonds

Breakeven inflation (BEI) rates offer a window into the market’s inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.1

The one-year BEI shows a spike in inflation expectations this year following increasingly high consumer price index (CPI) changes. But the trajectory appears to have changed course over the past couple months. Since peaking at 6.3% in late March, the one-year BEI had fallen to 5.2% as of June 10.

This might be the market’s way of telling us it sees inflation getting under control in the near future.

1-year breakeven inflation rate, January 1, 2021–June 10, 2022

Source Dimensional Fund Advisors

1 Moreaccurately,thedifferenceinyieldsbetweennominalandinflation-protectedbondsrepresents bothexpectedinflationandaninflationriskpremiumbornebyholdersofnominalbonds.

It is important to remember that realized inflation can diverge from expectations as the chart below shows.

While nominal (i.e., not inflation-protected) bond prices reflect expected inflation, investors who opt for Treasury Inflation-Protected Securities (TIPS) or approaches that overlay inflation swaps (“real return” bond strategies) get compensated for actual inflation. Investors who want to reduce uncertainty in the event of higher-than-expected inflation may benefit from these inflation-hedging approaches.

However, it’s important to remember that inflation-linked bonds tend to be very long term and are therefore susceptible to changes in the real interest rate and you can’t write a hedge against that so there is still a lot of uncertainty around how inflation-linked bonds perform in the short-term as the graph below illustrates.

Source: FE

We can see that although realised inflation has increased recently which has benefited inflation-linked bonds, the market has projected an increase in expected future interest rates which has had a greater negative impact in the short-term.

Extending investment terms too far may result in diminishing returns/risk trade off.

Not all investors define risk as volatility as measured by standard deviation . Some invesors (such as Insurance Companies) may seek to hedge long-term liabilities using long-term bonds.

Historically, longer maturity instruments have higher volatility and have not provided consitentaly greater returns.

Surely Bonds are a Return Free Risk?

This is where you need to be careful what you read. It is true that the capital value of a bond is inversely related to interest rates and therefore falling (or rising) interest rates result in rising (or falling) bond prices.

However, the bond index funds we use in our client’s portfolios have stable durations. What this means is that they generally hold bonds with a particular term to maturity. As these bonds mature, they turn into cash and are reinvested.

Since interest rates have gone up, this cash is now reinvested at a new higher interest rate. This constant process of maturing and reinvestment results in a wonderful side effect which is that short-term high credit bonds are a reasonably good hedge against inflation.

Dataasat31stAugust2021

ComparedtotheendofMay2022

Source: Vanguard

We can see that the average Yield has increased from 0.31% in 2021 to 2.87% at the end of May 2022. Investors in the fund or cash being reinvested from maturing bonds are now earning more than 2.5%pa more than in August last year.

The 1970s

Ok, but what about the 1970s? Inflation was out of control and commodities were the thing to own.

So, yes commodities were a relatively good bet for that decade but look how much volatility they come along with

You are trying to hedge something which looks like this from month to month:

With something that behaves like this:

And we can see what a big component oil represents in that index:

Which would explain why it did so well in the 1970s when OPEC doubled and then re-doubled the price of oil.

But if we take a step back and look at this in context, we can see that commodities are of questionable benefit in a portfolio when compared to bonds.

And the same is true of precious metals:

Which generally don’t perform much better than cash over time but have ridiculous levels of volatility relative to inflation: