Market Outlook

Depressed Inflation and Growth: Unlikely

By Douglas Wade, Western Asset
26 March 2020

Inflation may stay subdued, but should move above the levels implied by current breakeven inflation rates once it's apparent that economic recovery has begun.

Since the beginning of the year and with the onset of the global coronavirus outbreak, inflation expectations have plummeted (Exhibit 1). This is due to concerns over falling global demand as business activity is at a standstill with people throughout the world hunkering down to avoid COVID-19 infection, and an unexpected price war between Saudi Arabia and Russia that has caused the spot price of crude oil to collapse. While both the coronavirus and the oil price collapse are deflationary events for 2020, we believe they will likely have much less impact on future years. Oil prices are unlikely to fall from their current levels as much as they have fallen recently. In fact, oil futures are now implying higher energy inflation in one to five years’ time than it was earlier this year, when oil futures were in backwardation. This implies that the drop in core inflation expectations has been even sharper than the drop in total inflation.

While no one has a crystal ball to predict accurately the length and severity of the current downturn, or to be sure what inflation will be in five years, it seems unlikely that the market has permanently changed its view that future inflation will be substantially lower over the longer term. Recent measures by the Federal Reserve and Treasury have caused a substantial bounce in long-term breakeven inflation rates, though they remain below pre-OPEC+ collapse levels.

Exhibit 1: Future 5-Year Breakeven Inflation vs. 30-Year Real Yields

Source: Bloomberg. As of 23 Mar 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Exhibit 2 illustrates the enormity of the decline in breakeven inflation rates. Breakeven inflation is the difference in yields between a nominal government bond and an inflation-linked security of the same maturity—it’s the inflation rate you need to break even between either investment.

Exhibit 2: Global Inflation Expectations and Trends

Source: (A) Bloomberg. As of 09 Mar 20 (B) J.P. Morgan. As of 31 Jan 20. Past performance is no guarantee of future results.This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The line chart on the right-hand side of Exhibit 2 makes the point that the interest rate decline we’re seeing is occurring in an environment in which inflation was already very, very muted all over the world.

The table on the left-hand side indicates the inflation rates that you would need to see over the next 10 years in order to justify the investment in long-term bonds. These are at spectacularly low levels.

From an investment standpoint, these breakeven inflation rates represent the expected inflation in each of these countries going forward for the next 10 years. To place into context, these inflation rates are lower than any experienced after the Great Depression in these countries.

Think about that for a moment. These breakeven inflation levels mean that going forward, the market expects inflation lower than anything we’ve ever seen that will persist not just for a year or two but for over 10 years. It’s indicative of the market’s concern that policymakers around the globe are completely incapable of practically ever achieving any uptick in inflation again. It reflects incredible pessimism about both growth and inflation for a very long period of time.

At Western Asset, we take the other side of this trade. We recognise that the impact of COVID-19, both in human and economic terms, is immense. However, we view the virus as an exogenous shock to the system that will run its course, however painful that may be, and then dissipate.

While the contours of the eventual recovery are not known, we suspect the economy will recover from this shock as people come out from quarantine, businesses reopen and travel normalises. Inflation may remain subdued relative to historic levels, but should move above the levels implied by current breakeven inflation rates once it becomes apparent that economic recovery has begun. As such, we have added modestly to long-dated inflation-linked securities in appropriate strategies given both the fundamentals—our expectation of higher inflation post-coronavirus—and today’s compelling valuations of inflation-linked securities.



COVID-19 is the World Health Organization's official designation of the current coronavirus disease.
Deflation refers to a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money.
Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.
Core inflation refers to the general inflation rate for consumers but excludes relatively volatile food & energy prices.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Organization of the Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 12 oil-exporting developing nations that coordinates and unifies the petroleum policies of its member countries.
OPEC+ includes the 11 OPEC members and 10 non-OPEC nations, including Russia.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
nominal government bond is a bond that has has no provision for inflation other than its price or yield, as opposed to an inflation-adjusted bond, which has provisions for adjusting its return to take into account the prevailing rate of inflation.
Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
The 5-year and 10-year forward breakeven inflation rates are measures of expected inflation derived from "nominal" Treasury securities and their "real" counterparts—inflation-protected TIPS securities, for the 5- and 10-year periods ahead.
30-year real yields are calculated by adjusting stated yields of 30-year Treasuries to compensate for inflation expectations over the 30-year time period during which the yields are expected to be paid.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
GDP-weighted value is calculated by taking into account the relative size of the countries' economies.
The Group of Ten (G-10 or G10) refers to the group of countries that agreed to participate in the General Arrangements to Borrow (GAB), an agreement to provide the International Monetary Fund (IMF) with additional funds to increase its lending ability.
The Bloomberg service delivers business and markets news, data, analysis, and video to the world, featuring stories from Businessweek and Bloomberg News.
J.P. Morgan is part of JPMorgan Chase & Co. (Trading symbol: JPM) is a global banking and financial services holding company headquartered in New York City. The firm has more than 40 operating subsidiaries employing roughly 240,000 people in 60 countries around the world.
In economics, an exogenous shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it is an unpredictable change in exogenous factors — that is, factors unexplained by economics — which may influence endogenous economic variables.

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