Investors rush to protect from surging costs, stagflation threat

(Bloomberg) — Investors rushed to buy bonds that shield them from the prospect of accelerating inflation after the Russian military launched an attack on Ukraine on Thursday.

The assault drove the price of key commodities sharply higher, pushing gauges of near-term inflation expectations in U.S., Britain, and Europe to a record. The move put the 10-year U.K. real yield on course for its largest drop since the aftermath of the 2016 Brexit vote, and the equivalent German rate toward its biggest decline since at least 2009. In the U.S. five-year real rates plunged more than 30 basis points — exceeding their slide during the peak of pandemic concerns in 2020.

Rising inflationary pressures were combined with concern that they add to risks for a global economic slowdown, and environment dubbed as stagflation. That’s especially true as surging energy prices put even more pressure on central banks to tighten policy. While money market traders pared back slightly Thursday the degree of central bank policy hikes to expected this year, overall they remain well intact with the Federal Reserve seen doing just under six quarter-point increases in 2022.

“This puts the performance of inflation solidly back into the limelight” with the “risk that higher prices with the backdrop of heightened geopolitical uncertainty will ultimately be stagflationary,” BMO Capital Markets strategists Ian Lyngen and Benjamin Jeffery wrote in a note. “An energy crisis is the most direct path to stagflation; and an unfortunately familiar one.’

For Althea Spinozzi, a strategist at Saxo Bank, central bank policies would need to be even more aggressive to make breakeven rates adjust lower.

“However, central banks will be reluctant to hike aggressively in the midst of a war as they could cause growth to slow down significantly,” Spinozzi said.

The U.K. 10-year breakeven rate rose to the highest level in more than two and a half decades while the equivalent German one above 2% for the first since 2011. U.S. five-year peers jumped to an all-time high of 3.33%. The gauges represent the difference between conventional yields and those indexed to inflation, and provide an estimate of the future pace of price increases.

Traders are front-loading their inflation hedging. Two-year breakevens in both Germany and the U.S. are trading at record highs relative to their 10-year equivalents.

“The ongoing inversion of the breakeven curve continues to comport with the view that higher inflation today will result in lower inflation further out,” said Rabobank strategists including Richard McGuire. “The Ukrainian situation is resulting in yet a further and very significant intensification of the binary risks facing policymakers as cost-push price pressures surge and downside risks to growth mount.”

One-year inflation swaps in the euro area jumped 56 basis points to 4.75%. The U.K. rate jumped 115 basis points to 8.05%.

“The stagflation that is here and will now get worse has made the job of the world’s central banks now impossible to maneuver,” Peter Boockvar, chief investment officer at Bleakley Advisory Group, said in a note. “And yes, the Fed is still ending QE” its bond-buying program “in a few weeks and raising rates by 25 basis points.”

(Adds strategist comments in fourth paragraph, updates prices throughout.)

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