Per the Fisher equation, nominal interest rates can be broken down into two distinct components: real rates and inflation expectations. To protect against rising real rates, investors should consider outright negative or shorter-duration interest rate exposures. To protect against rising inflation expectations, investors could investigate inflation-linked bonds, known as “TIPS” in the US and “Linkers” in Europe.
During the COVID-19 pandemic, both real and inflation rates fell dramatically.
In the US, for instance, real rates fell as the Federal Reserve cut its base rate by 150 bps in response to the coronavirus outbreak. At the same time, inflation expectations plummeted, with market-based indicators, such as forward-looking inflation swaps, reaching lows.
In an effort to contain the economic fallout, governments and central banks reacted swiftly. Enormous stimulus packages were set up by fiscal authorities, and those responsible for monetary policy increased the size and scope of their quantitative easing programmes.
Following these measures, inflation expectations have today recovered on both sides of the Atlantic, with inflation break-evens in the US, for instance, now close to multi-decade highs. According to the Fisher equation, this upswing in inflation expectations has impacted nominal rates, and those who invested in inflation-linked bonds over this period will have enjoyed capital gains on their exposure.
Looking forward, nominal interest rates should continue to rise but the drivers of this trend should shift from higher inflation expectations to higher real rates.
Inflation prints are likely to remain volatile as supply chains which were negatively impacted by the pandemic recover and fiscal stimulus measures are unwound. For example, German core inflation is likely to see a large jump in mid-summer, as the impact of the delay of VAT payments is reversed.
Notwithstanding this noise, the Federal Reserve’s analysis that increases in inflation will be “transient” is sound, and strong disinflationary forces, such as weakening demographics, technological advancement and labour market slack, will cap excessively rising prices.
However, as economies reopen, the COVID-19 vaccine roll-out continues and growth accelerates, investors will probably shift allocations away from low-yielding safe-haven assets, such as US Treasuries and German Bunds, which would impact real rates and lead to rising nominal rates. In such a scenario, inflation-linked bonds would actually suffer capital losses.
In conclusion, the trend of rising nominal interest rates is likely to continue, but it will be driven by increasing real rates rather than inflation expectations. Investors looking to limit or even benefit from a rising real interest rate environment over the medium term should rotate away from inflation-linked bonds and position themselves with short or negative interest rate exposures.
Philippe Gräub
Head of Global & Absolute Return Fixed Income
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Bernard McGrath
Senior Investment Specialist
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