Navigating Uncertainty in Inflation Markets: The UK Case

Investors in UK inflation-linked bonds are facing two critical sources of structural uncertainty: volatility arising from the Brexit process, and questions about the deeply entrenched (yet problematic) Retail Price Index (RPI), to which UK “linkers” are tied.

Navigating these uncertainties – and the pricing dislocations they may produce – requires a thoughtful and responsive investment approach that aims to sidestep risk while seizing opportunities that may arise.

Brexit-related volatility persists

On 23 June 2016, as the results of the UK referendum to leave the EU were revealed, markets sought an equilibrium in a highly uncertain scenario. The pound weakened, leading to higher breakeven inflation expectations (see chart). Notably, breakeven inflation has remained elevated, indicating that uncertainty persists and markets remain far from a stable destination. Just last week, British lawmakers rejected the proposed Brexit deal for a second time, while also rejecting a no-deal outcome and approving a motion to postpone the Brexit date. Though hurdles remain, the base case seems to suggest an extension of the current 29 March deadline, which would likely result in lower breakeven inflation over the short term.

Regardless of the near-term parliamentary debates’ outcome, we should not forget that the real negotiations about the UK’s relationship with the rest of the world have yet to begin, and will likely last for years. The final impact on tariffs, currency movements and monetary policy could spur large moves in breakeven inflation in both directions, requiring a dynamic approach to managing positions in inflation-related assets.

U.K. bond yields and breakeven inflation before and after the Brexit referendum