There has been a lot of talk in recent months about the strong recovery in inflation. Monthly CPI surveys, both in the US and in Europe, were between + 7% and + 8%. If, to protect ourselves from this risk, at the beginning of 2022 we had bought and included in our portfolio the bonds linked to inflation (the so-called inflation linked bonds), would we have had positive returns? Unfortunately not.

I propose a chart where I report the price trend of an ETF that invests in US inflation-linked bonds (US Inflation Linked ETF, in blue on the left-hand scale). As can be seen from the chart, from November 2021 to today, the return given by the instrument has been negative and equal to approximately -10.52% (from a price of 131.37 to a price of 117.54 – both prices are highlighted with a blue circle). How can this result be explained? The sharp rise in real rates (represented by the inverted red line on the right scale in the graph). In fact, the sudden change of attitude of the Fed in the stance of monetary policy in favor of a rise in interest rates and a reduction in liquidity in the system has led to a sharp rise in real rates.

The real rate (together with the risk premium) is the discount factor for all financial assets (asset classes). The lower the real rate, the lower the discount factor and therefore the current value of the asset class to be evaluated is high. Conversely, the higher the real rate, the higher the discount factor and, consequently, the lower the value of the asset class we are analyzing.

The chart clearly shows how the price trend of the ETF investing in US Inflation Linked ETFs is highly correlated (R2 @ 96) with the reversed trend of the implicit real rate in 10yr US Treasury, on the right in red, expressed in bps (basis points). It is the upward movement of the real rate from -125bps to +25bps (+ 150bps) that determines the loss of -10.52% of the US Inflation Linked ETF.

 

US Inflation Linked Bond & US Real Rates