British linkers capitalising on Brexit

2018 could have been a decent year for bonds indexed on inflation. After all, the United States, United Kingdom, Germany and several other countries are at full employment. And yet, breakeven inflation rates are often at lows for this year (see Focus). Having tumbled in the latter part of the year, crude oil prices are the main culprit, but not the only one. It is conceivable that the end of the cycle will bring with it a few inflation spikes here and there, but all this won’t amount to much. The reasons why inflation is in the doldrums and why Philips curves are struggling to function normally have not vanished (slowdown in productivity gains, wilting negotiating clout of the trade unions, etc.). More recent developments that could, potentially, be inflationary (notably the trade war) have not yet had a significant impact on prices. In particular, the trade war between the United States and China would have to escalate seriously. Donald Trump’s strategy is to tear up trade agreements and slap on customs tariffs to strengthen the United States’ negotiating clout (so as to reach supposedly more favourable trade agreements, as with the USMCA, or simply redefine the playing field). In the primary markets, linkers have struggled to elbow their way back to where they were before. The main exception is the United Kingdom, where linkers account for around 25% of total medium- and long-term issuance, a percentage that has been relatively stable this year. The other exception is France, where linkers once again account for 10% of total issuance (see this Month’s chart). In the United States, TIPS issuance declined as a percentage of total Treasury issuance in 2017 and again in 2018, reaching just 7% from January until the start of December. In Germany, the market is a shadow of its former self, accounting for just 4.6% of issuance. One of the big unknowns next year is the level of British inflation. It could increase sharply in the event of a no-deal Brexit, due to sterling, but also because certain staples (food notably, but not only) could become hard to come by. If there is a deal, possibly even a no Brexit, inflation would be likely to subside as sterling would bounce back. Staying long index-linked Gilts against conventional Gilts was a good strategy: in the event of a no-deal Brexit, breakevens will track inflation higher. In the event of a deal, breakevens will increase, tracking the rise in nominal interest rates. It is now more difficult to enter into this type of strategy given the levels reached by breakevens for index-linked Gilts.