Inflation linked bonds have doubled but may not be best trade

Baring Asset Management –

If, as central bankers say, it is the exogenous factors, such as commodities and food, that are driving inflation higher, the ones that they cannot control, then it makes sense to get exposure to them.”

This is an interesting argument for commodity exposure but makes sense. If the commodity prices will always be independent of central ban action, it would seem that this is the area of most potential risk. Obviously, if the central bank wants to generate inflation, then inflation linked bonds would be a better option. However, governments actually control the measurement of inflation.

The supply of inflation linked bonds have increases substantially over the last five years with the size doubling in France, UK and the US, but the size of deficits have increased even more so the relative importance of inflation linked bonds may have diminished in many countries.

Governments may not want to stop the issuance because that will send a clear signal to the market that inflation is going higher, but they really do not want to index all of their debt to inflation rates which are headed higher. Certainly inflation rates are near their lows in many G10 countries and have trended higher.

Inflation linked bonds have not been a great deal for investors because real rates have moved into negative territory. Paying the government to hold your money when they also may control inflation is not something that seems to be a good trade.Currently 5 year TIPS in the US are trading at -.28 yields The 10-year TIP is positive at 1.13 percent.

So how can investors escape the inflation cycle? An investment in commodities may serve as a useful addition to portfolios.There will be a price gain from the movement in commodities with a cash return based on the investment in futures.