Inflation: the missing linker

Australian investors do not expect an inflation breakout. However, they say inflation-linked bonds still have a role and expect the Australian Office of Financial Management (AOFM) will continue to meet demand.

The outlook for inflation in Australia is largely driven by oil prices, energy and – in the near term – the direction of the currency. While the Australian dollar has been falling, its inflationary impact is hard to maintain.

“The impact of the currency on inflation is only temporary – to repeat it the Australian dollar would need to fall consistently quarter after quarter,” says Tamar Hamlyn, principal at Ardea Investment Management. “The medium-term impact is driven by demand and economic activity. In Australia, consumption is subdued, we have high debt levels and we don’t have the type of organically strong domestic demand that could give us an inflation problem over the next 3-5 years.”

The global inflation outlook is no different. With demand internationally not sufficiently robust to spark inflation, Justin Tyler, director at Daintree Capital (Daintree), says an inflation dynamic in any single market is not likely to be sticky. In this global environment, idiosyncratic inflation in a single jurisdiction is likely to be diluted by currency adjustment.

Tyler explains: “The currency markets will continue to move the inflation poles around until there is sufficient global demand to bring about a global upswing in inflation.“

Such a breakout does not appear to be imminent. “We didn’t get inflation when the Federal Reserve and the European Central Bank were rapidly expanding their balance sheets, so the chances of getting it when they are shrinking them is reasonably remote,” comments Darren Langer, senior portfolio manager at Nikko Asset Management.

Markets continue to price in minimal inflationary expectations. By mid-January 2019 the Australian market outlook was for 1.3 and 1.8 per cent inflation over the next four and 10 years.

Anne Anderson, head of fixed income and investment solutions, Australia at UBS Asset Management, says: “Break-evens at these levels and the Reserve Bank of Australia’s target at 2-3 per cent for the next four years implies the reserve bank is undershooting its target.”

JUSTIN TYLER

The currency markets will continue to move the inflation poles around until there is sufficient global demand to bring about a global upswing in inflation.

JUSTIN TYLER DAINTREE CAPITAL
Linker demand

Equally, though, real-money investors are not complacent about the sustained low-inflation environment. Hamlyn says having what is effectively a government hedge on inflation via inflation-linked sovereign bonds is an effective tool for investors and offers good diversification benefits within portfolios.

“We are relatively subdued on the outlook for inflation, but this is not to say investors shouldn’t hedge against it,” Hamlyn tells KangaNews. “Anything can happen and there is still a chance that inflation could prove to be problematic. We just don’t think the odds are especially high.”

The AOFM has maintained a supply of inflation-indexed bonds but only as a relatively small component of its overall programme. For instance, in 2017/18 the debt-management agency issued A$5.5 billion (US$4 billion) of linkers (see chart) alongside A$81.1 billion of term debt.

The AOFM’s net new-issuance task is declining, but investors are confident linkers will continue to be part of the story. The Australian government stopped issuing in this format entirely ahead of the financial crisis, returning to the market in 2009. With a larger outstanding supply of bonds to maintain and an eye to the long term, investors are confident the market withdrawal will not be repeated.

Source: Australian Office of Financial Management 5 February 2019

Hamlyn explains: “Our understanding is that the AOFM sees some value in having a structural linker programme. Issuers learned during the financial crisis that it is all well and good to retire various funding capabilities when they aren’t needed but to reintroduce them requires significant work. We might see reduced issuance of nominal and inflation-linked bonds but our understanding is issuance will continue.”

Tyler adds: “I don’t think the AOFM will let the programme get too low. It provides access to a different investor base and diversifies its funding sources.”

At the same time, there is no expectation of a glut of linkers. “The AOFM is good at issuing into pockets of demand so I don’t believe it will flood the market with linker paper – unless there is demand for it,” Langer comments.