Systemic risk of deflation

Posted on 20. Aug, 2015 by Jean Jacques Ohana in Weekly Focus | 0 comments

As commodities slump is deepening (figure 1), the simultaneous drop of US breakeven inflation rates and surge of US 10 years real rates (figure 2) resulted in significant inflation-linked bonds underperformance.

US Investment Grade and US inflation linked bonds have significantly underperformed US treasuries onwards, highlighting defiance towards risky bonds and a quest for safety among investors (figure 3).

All assets have started to be related, one way or another, to the slump of commodities’ prices. For instance US Investment Grade, High Yield and even emerging debt spreads have widened in the wake of the fall of commodities (figure 4). Emerging currencies have plummeted and capital outflows threaten the financial stability of emerging countries. The surprise devaluation of the yuan has emphasized the vulnerability of emerging currencies like the Malaysian Ringgit, the Korean Won or commodity currencies like the Russian Ruble, the Brazilian real or the Mexican Peso (figure 5).

As a matter of fact, inflation-linked assets are the most connected asset class, being positively correlated to all types of bonds, emerging currencies vs. USD, commodity currencies vs. USD and negatively correlated to equities (figure 6). As the level of integration among financial markets (figure 7) has risen significantly since May, the systemic risk of financial markets is the threat of the decade: deflation. This disease is highly contagious since every country is likely to infect its trading partners by currency devaluation, the only applicable beggar-thy-neighbor strategy in an anemic growth mode. There is no doubt that the Fed will be sensitive to the sharp rise of the dollar index (+18% over a year) in setting its monetary policy.


Figure 1: The commodities tumble is more acute.

Figure 2: US 10 years breakeven inflation rate (blue) and US 10 years real rates (red).

Figure 3: Compared performance of Inflation Linked Bonds, Investment Grade Bonds and US Treasuries.

Figure 4: US HY and IG Energy Option Adjusted Spreads (OAS), CDX emerging spreads as well as US Investment grade OAS have climbed to multi year highs.

Figure 5: The slump of emerging markets currencies in 2015.

Figure 6: Average correlation between groups of assets over a 6 months period.

Figure 7: Level of financial markets integration. This indicator corresponds to the proportion of the global asset price variations (i.e. the equities, corporate credit, currencies, bonds, interest rates futures, and commodities’ price variations) which can be explained by a common risk factor, viewed as the average dynamics of risky assets against bonds.


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