Blog

Navigating Uncertainty in Inflation Markets: The European Case

Eurostat’s recent revision of the HICPxT index could have two potentially wide-reaching effects for euro area inflation-linked bonds (ILB) investors.

Recently, a change in the measurement of one subcomponent in Europe’s key inflation gauge prompted a significant recalculation in the entire index. Investors in euro area inflation-related assets now find themselves in a more uncertain environment. We believe an active, flexible portfolio approach could help.

On 22 February 2019, the German statistics office revised the methodology for calculating prices of package holidays. Despite their small weight in the Harmonised Index of Consumer Prices excluding Tobacco (HICPxT), package holidays tend to be one of the most volatile subcomponents. Subsequently, Eurostat, the statistical office of the European Union (EU), incorporated these methodology changes and also revised Europe’s aggregate EUR HICPxT index going back to January 2015. This index is the EU’s main inflation measure: The European Central Bank (ECB) uses the index in setting monetary policy, governments use it as the baseline to calculate payments on euro area inflation-linked bonds (ILB), and other market participants use it to price inflation swaps. In our view, Eurostat’s revision of the HICPxT index – both backdated and going forward – has two potentially wide-reaching effects.

First impact of revision: seasonality

The new methodology has not changed the historical average annual inflation rate, but it has changed the seasonality of inflation throughout the year (driven by demand for seasonal goods), leading to higher seasonal volatility for the HICP-linked bonds. After the revision, seasonal inflation will tend to be higher in the first half of the year and lower in the second half, especially in November. This in turn affects inflation-linked instruments maturing on different dates throughout the year.

HICPxT: Average month-over-month price change (%) since 2015, relative to trend

Second impact of revision: rebasing

It is not uncommon for Eurostat to revise a methodology, but it is rare for it to be accompanied by a rescaling of the index series. The old series had a base in 2015 (i.e., the average of 2015 index levels equals 100), but the revision has distorted that. Eurostat decided to apply a scaling ratio of 0.9984 to force the averages of the revised index values in 2015 back to 100.

Some are questioning whether the change should be treated as an official rebasing. Mathematically, there has been a rebasing, in the sense that the index has been rescaled, resulting in a 16 basis point (bp) difference between the old and new series, all else equal. However, a typical rebasing occurs when the base year is changed and the index renormalized. February’s rebasing happened in coincidence with a methodology revision, and the base year remained the same (2015). While the mathematical impact is effectively the same as changing the base year, the interpretation is not as straightforward. This has created confusion in the inflation market, resulting in reduced liquidity as market participants tried to understand what happened. Eurostat added further ambiguity by initially referring to the rescaling key as an “implicit rebasing key” (they subsequently amended the wording).

The uncertainty creates an issue for inflation-linked bondholders as ILB payments refer to the unrevised index series. In the absence of an official rebasing, inflation accrual for inflation-linked bonds calculated between December 2018 and January 2019 compares two indexes with a different base, resulting in a lower accrual by 16 bps than what would happen in the case of rebasing.

We believe uncertainty calls for an active approach

While some market participants have taken a wait-and-see approach to these developments, PIMCO used the opportunity to estimate the impact of potential index changes, update our models with the new information, evaluate relative value (RV) opportunities, and modify positions accordingly. For example, in some markets, RV opportunities between bonds with different maturity months were created as the new seasonality patterns were not fully discounted. This created an opportunity to switch from bonds negatively impacted by the seasonality change into those that were positively impacted.

We believe the HICP changes, on top of the uncertainty facing the UK inflation-linked bond market, underscore the importance of an active investment approach that has the flexibility to manage the risks of the unexpected and potentially capture opportunities when they arise.

Enjoyed this article? Subscribe to receive updates to the PIMCO Blog.

SUBSCRIBE
The Author

Lorenzo Pagani

Head of European Government Bond Portfolio Management

View Profile

Latest Insights

Related

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

All investments contain risk and may lose value and there is no guarantee strategies will be successful. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. A low interest rate environment increases this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise.

XDismiss Next Article