Rising UK Inflation: What does it mean for breakevens?

Research Team at RBC Capital Markets look at the implications of expected sharp rise in UK inflation over the coming few months on breakevens.

Key Quotes

“The coming few months are likely to see a sharp rise in the headline inflation rate in the UK on the back of significant impact from energy price base effects and as the exchange rate pass-through becomes dominant. As detailed in our recent note, CPI inflation is seen rising from 1.2%y/y in November to 2.0% y/y in January - this will be the steepest rise over a two month period in seven years. While such a sharp rise in inflation will certainly grab the media headlines and raise further doubts over the BoE’s ability to loosen monetary policy further, our own take is that a weak growth outlook will ultimately serve to dominate the MPC’s thinking and lead them to announce further QE in 2H 2017.”

“When looking at the market implications of such a rapid rise in inflation, we expect this backdrop to remain constructive for breakevens in general. However, we think that short-dated breakevens, which are already trading at historical highs, are pricing much of this rise in headline inflation and at these levels are vulnerable to a negative shock. Instead, we see several factors that should be supportive of longer-dated breakevens on a relative basis, and with the forward inflation curve close to being inverted, we see scope of a steeper breakeven term structure.”

“We suggest positioning for a steeper 5s30s IL swap curve over the medium term and we maintain our target of 40bps on the slope. In the near-term, there will be a notable lack of long-end IL issuance for about 6 weeks once today’s 30yr linker supply is out of the way. We think the timing is ripe to initiate a BEI curve steepening exposure heading into today’s supply. Thereon, any tactical flattening in the breakeven curve into the long-end IL syndication in 2H February should be seen as an opportunity to add to the steepening exposure, in our opinion.”

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