gas-price inflation

The rise in gas prices caused by the Ukraine situation has rekindled demand for inflation hedges.

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As the war in Ukraine threatens to worsen already high energy prices, market-based inflation indicators are flashing red, prompting investors to seek shelter in the inflation-linked bonds they had ditched since January.

While safe-haven demand has benefitted government bonds, rising energy costs have boosted advances in inflation-linked debt in Europe and the United States. Inflation-linked debt is defined as securities whose face value and interest payments rise in lockstep with inflation.

“UK inflation has been quite bid at the front end, and that’s really simply indicative of the front contract on natural gas,” said Royal London Asset Management’s head of alpha strategies, Paul Rayner.

Since the beginning of last week, yields on British one-year inflation-linked bonds, or linkers, have plunged 80 basis points, striking a historic low of -7 percent and predicting an inflation rate of almost 9% at one time. (GB1YIL=RR)

Bond yields are inversely proportional to bond prices.

The Bank of England predicted that inflation would hit a 30-year high of roughly 7.25 percent in April, when a 54 percent increase in regulated residential energy costs takes effect.

The two-year inflation-adjusted yield in Germany, the largest user of Russian gas, has fallen 60 basis points since the beginning of last week, implying an inflation rate as high as 3.7 percent, compared to 2.4 percent at the start of February. (DE2YIL=RR)
The changes in the United States are minor, with one-year Treasury Inflation Protected Securities (TIPS) rates down around 20 basis points. (US1YTIP=RR)

According to EPFR data, TIPS had their first inflows in five weeks for the week ending Feb. 23.

Many people warn that inflation rates predicted by linkers are skewed by factors including liquidity, central bank purchases, and, in the United Kingdom, massive pension fund demand.

However, energy prices clearly risk exacerbating already-high inflation; according to Deutsche Bank, a 50% increase in gas prices and a 20% increase in oil prices would push European Union inflation to 5.7 percent in 2022, a percentage point higher than forecasts in the absence of a Russia-Ukraine conflict.

Growth would fall to 2.8 percent, significantly below the European Commission’s forecast of 4% for 2022.

In a “medium scenario,” the European Central Bank’s chief economist has advised policymakers that the conflict may cut output by 0.3 percent to 0.4 percent.

“(Stagflation) has obviously become more plausible,” Patrick Krizan, senior economist at Allianz in Munich, said.

The risk of a negative impact on growth could stymie central banks’ efforts to tighten monetary policy in the aftermath of the outbreak. The Bank of England may scale back its next rate hike, while the European Central Bank may hold off on making strong commitments.

“What’s intriguing about inflation-linked bonds is that you get exposure to inflation risk while also being almost a safe-haven asset, so I believe it makes it doubly attractive,” Allianz’s Krizan explained.

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