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Christophe Dehondt : « Current levels of inflation break-even are buying opportunities »

According to Christophe Dehondt, fund manager of CPR Focus Inflation, it is possible to benefit from the rise in inflation while being hedged against rising interest rates by buying inflation-linked bonds and selling traditional sovereign bonds with similar maturity...

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What are the factors behind the recent decline in inflation expectations ?

In recent weeks inflation expectations (or break-even), measured by the difference between a nominal bond and an inflation-linked bond with the same maturity, decreased. This movement took place uniformly over the entire American break-even curve, and focused on maturities of less than 10 years in the Eurozone. Between their highest level since the beginning of the crisis reached in early April (2.65% for the 10-year US break-even and 2.40% for the 10-year euro break-even), and the end of May, inflation expectations to 10 years lost about 40 basis points. This move follows the downward revision of both global growth and energy demand, which had the effect of reducing oil prices (WTI) close to $100 a barrel after peaking at $113 in early May.

Don’t you think that this decline come as a consequence of high valuation levels ?

We do not. This decline, partly due to many buyers speculative positions on some commodities, has lead the break-even to its low values range over the past 5 years preceding the crisis. This means that markets do not price additional risk premium despite the higher world growth expectation in the coming year, but also the persistence of inflationary pressures in emerging economies and the expansionary monetary policies of developed countries’ central banks (Fed ECB, BoE and BoJ) via a significant increase in the size of their balance sheet and very low key rates. In these countries, observed inflation bounced back after hitting a low in late 2010. Beyond the development of very erratic energy prices, a basic trend is emerging: the gradual spread of the rise in commodity prices through the production line illustrated by a rise in associated inflation. On this specific point, a growing number of companies now report being able to pass on rising commodity prices to their customers, something they have not been able to do for years. In addition, we need to take in account the industrialized countries’ temptation to welcome higher inflation than in the past in order to reduce the debt burden.

What is the break-even potential increase on the medium term ?

We believe that the current decline offers good buying opportunities on break-even to the extent that our central scenario remains unchanged (moderate recovery in developed countries). Given current inflation levels, we expect an upside of 2.80% (against 2.30% now) on the 10-year US break-even and an upside of 2.50% (vs. 2.05%) on the 10-year euro breakeven, especially if tensions persist in the Middle East and the Federal Reserve confirms its confidence in the sustainability of growth by ending its quantitative easing. Speculation on commodities only brings the volatility around the trend that is structurally bullish with an offer that is lower than demand.

What about a fear of central banks’ over-reaction ?

In this context of a moderate strengthening of the activity, central banks carry out gradual normalization of their monetary policy. Considering the upside risks on prices, the ECB (whose sole objective is a price stability at a level close to 2%), has clamped down at its meeting in early March and increased its key rates by 25 basis points at its meeting in early April. While other key rate increases are already expected by the market, the Central Bank retains a relatively accommodative monetary policy.

The ECB has certainly worried about the possibility of the emergence of “second-round effects” but the fragile situation on the labor market slows down the transmission of prices to wages. In the United States, although interest rates should remain unchanged for a few months, the Federal Reserve is preparing markets for an end of its quantitative easing policy in the summer. Keeping resumption of growth a priority as well as the return of an equal employment with the fight against inflation, the Fed is expected to remain accommodative for a few quarters in view of persistent concerns about the labor market, and the still depressed housing market. To sum up, the slightly negative real interest rates still favor the maintenance of favorable financial conditions.

How to benefit from renewed rise in inflation while being hedged against rising interest rates?

The CPR Focus Inflation fund, provided by CPR AM, offers an exposure to inflation while providing a hedge against rising interest. It is actually a “pure implied inflation” fund. To achieve its goal, the fund is long implicit inflation without incurring exposure to real rates, i.e. the portfolio is long inflation-linked bonds and short sovereign bonds with similar maturity. As if today, a rise in "break-even" levels in line with our expectations would be likely to result in a performance of about 5% of our CPR Focus Inflation fund.

Next Finance , June 2011

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