Spectre of stagflation

The “spectre of stagflation” is no longer just a ghost story from the 1970s; it is rapidly becoming the primary concern for global bond markets. Only a few weeks ago, the consensus was leaning toward a “rosy” base case for both equities and bonds, fuelled by expectations of an AI-driven disinflationary trend and a potential supply glut that could have pushed Brent crude as low as $60.

Today, that narrative has flipped. With oil prices recently surging above USD100, the market is grappling with a reality where inflation stays sticky and growth starts to falter.

The Return of a 1970s Headache

To understand our current predicament, we have to look at what “stagflation” actually entails. It is the unenviable trifecta of a stagnant economy, rising unemployment, and increasing inflation. While recent US data shows a resilient economy, there are growing cracks in the labour market and persistent inflation.

Stagflation remains a scenario. This doesn’t mean it will happen, only that it is being factored in.

Today’s context also differs significantly from the 1970s. We are now contending with levels of government debt that would have been unthinkable fifty years ago, alongside rapid technological progress and massive wealth inequality. While we should be wary of saying “this time is different,” these structural shifts change how central banks and markets react to price shocks.

The immediate bond market reaction has been to price-out rate cuts and price-in some hikes. A lot depends on the starting point, which was more than a single 25bp cut previously expected in the UK and US, and the chance of a hike in the Eurozone, for example. Markets are only pricing the chance of stagflation, knowing that central banks have historically tended to look through oil price shocks.

The Mechanics of Inflation-Linked Bonds

As the risk of stagflation increases, investors might think about turning to inflation-linked bonds (or “linkers” in the UK and “TIPS” in the US). In theory, these should be a good hedge: they provide a principal adjustment based on inflation rates, protecting the purchasing power that conventional bonds lose during inflationary spikes.

A key metric here is the breakeven inflation rate – the market’s expectation of inflation over a specific period, derived from the difference between nominal (the yield on a conventional bond) and inflation-linked real yields.

As illustrated in the chart, we are seeing a fascinating divergence in these expectations:

• The US: Breakeven inflation has remained remarkably stable between 2.2% and 2.45%. This suggests high confidence in the Fed’s ability to hit its targets and reflects the US’s lower dependency on imported oil.
• The UK: Inflation expectations started from a higher base and have surged alongside oil prices. This has thrown the Bank of England’s path up into the air; just a week ago, the market was pricing in cuts, but those are now far less certain.
• The EU: While breakevens have spiked here as well, they started below the 2.0% level. This gives the ECB some breathing room to “look through” the shock. The market-implied risk of a hike has, however, increased, which might suit a hawkish forward guidance from some at the central bank.
  
  

The Reality Check: Real Yields and Liquidity

If inflation-linked bonds are such a great hedge, why haven’t they performed better recently? The answer lies in the “starting point” of real yields. In 2021, real yields were forced deep into negative territory – more than 300bp below zero in the UK and minus 100bp in the US – because central banks held nominal rates at the zero bound while inflation expectations climbed.

While inflation-linked bonds around the world now offer positive real yields, serve as a defensive alternative to cash and offer some diversification benefits, they carry a hidden danger: liquidity risk.

The market for inflation-linked bonds is much smaller and less liquid than conventional bonds. In the US, they make up less than 10% of sovereign issuance, compared with about one-quarter in the UK. When markets go “risk-off,” liquidity can evaporate. We saw this during the Global Financial Crisis (GFC, 2008). Linkers suffered a paradoxical sell-off – ie they were not a safe place to put money – as investors fled to the safety of more liquid conventional markets, amplified by deleveraging and deflation fears reverberating across the global economy.

Strategic Outlook: Winners and Losers

The current oil shock creates a clear divide: oil-producing countries stand to win, while importers – particularly small, open economies sensitive to global trade – tend to lose.

So, is it better to buy inflation-linked bonds or conventionals? And what about regional preferences?

• The Bear Case for Linkers: The traditional central bank playbook is to “look through” energy spikes, viewing them as a “tax on consumption” that eventually slows the economy and lowers inflation. If the BoE, ECB and Fed stick to this and oil prices stabilise, breakevens will fall, and conventional bonds will likely outperform linkers. In this case there is more potential in UK conventionals.
• The Bull Case for Linkers: If the conflict in the Middle East persists and oil stays higher for longer, the stagflation scenario becomes more of a reality rather than a probability. In this case, those “long of breakevens” will continue to see short-term gains. US breakevens offer better value having lagged.
  
  

Inflation-linked bonds and Stagflation

Stagflation was a tail risk (less than 10% probability) just a few weeks ago; now, there are moments when it feels more like a coin flip (30-50%). With this in mind the valuations have shifted, especially in Europe and the UK, most vulnerable to the shift in energy prices.

Inflation-linked bonds should not be viewed as a “silver bullet” to be bought in isolation, but rather as a crucial tool for diversification and a hedge against a world where inflation might refuse to return back to target levels.

The coming weeks will be telling. If you believe the oil price spike is a temporary shock, stick with conventionals. But if you believe there is a realistic chance of a returns to the inflation of the 1970s, it might be time to increase your allocation to real assets, including inflation-linked bonds.