Oct 22, 2021 Inflation

Exceeding expectations

The relationship between the spot price for oil and bond-market expectations for long-term inflation rates has become tighter than ever.

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Forecasting inflation has always been a tricky business. Rarely more so, however, than in the aftermath of a once-in-a-century pandemic "when the basket of goods and services that we buy was so suddenly distorted out of all recognition."[1] Which makes all the more remarkable that one particular way of predicting longer-term inflation expectations continued to do surprisingly well.

Our Chart of the Week shows the spot price for oil vs. break-even inflation rates as derived from 10-year Bunds. The high correlation between the two – and similar metrics for U.S. Treasuries – has long delighted market practitioners. And yet, there are few clear-cut economic reasons why today's oil price should matter all that much for long-term inflation expectations in bond markets. Energy prices are continuously reflected in consumer price indices (CPI). Indeed, the strength in oil and commodity prices, along-side broader supply-chain disruptions, have been key drivers of recent inflation spikes. But today's high readings are next year’s base effects. That seems especially relevant for a commodity as prone to boom-and-bust cycles as oil. One might also expect decarbonization to lessen the correlation. Instead, it has strengthened since the start of the pandemic.

Bond-market inflation expectations vs. the oil price


* as derived from 10-year Bunds
Sources: Bloomberg finance L.P., DWS Investment GmbH as of 10/20/21

Three complementary explanations come to mind. Look closely, and the recent rise in break-even inflation rates has exceeded even the oil-price strength. "In practice, it sometimes takes a while for expectations to reflect new realities," points out Frank Engels, Global Head of Fixed Income at DWS. "The longer and stronger the rise in energy prices, the higher the probability that it shifts expectations." That holds not just for bond-market participants but also among unions making wage demands or firms thinking about their pricing strategy. Such second-round effects seem increasingly plausible, following the spectacular increase in energy prices over the past 18 months. Finally, the very fact that so much else seems uncertain might have led some market practitioners to rely even more heavily than usual on a tried and trusted tool – whether or not that makes sense in theory. 

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1. Goodhart, Charles und Manoj Pradhan (2020). The Great Demographic Reversal: Ageing Societies, Waning Inequality and an Inflation Revival. Palgrave Macmillan, pp. 214, who also pointed out early on that this has it “almost impossible (…) to put together sensible and meaningful data” for any inflation series. For more on the implications, see: https://www.dws.com/insights/cio-view/cio-view-quarterly/q3-2021/sense-and-nonsense-in-pandemic-times/

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