Inflation risk premia in the U.S. and the euro area have disappeared or even turned negative since the great financial crisis, according to various studies. There is also evidence that this is not because inflation uncertainty has declined but because the balance of risk has shifted from high inflation problems to deflationary recessions. Put simply, markets pay a premium for bonds and interest rate swap receivers as hedge against deflation risk rather than demanding a discount for exposure to high inflation risk. This can hold for as long as the expected correlation between economic-financial performance and inflation remains broadly positive.
The post ties in with this sites’ lecture on information efficiency through fundamental value research (particularly the part on fixed income markets).
Also this site contains a complementary post on research that shows how monetary policy at the zero lower bound reinforces concerns about deflation risk and, hence, negative inflation risk premia.
The below are excerpts from the paper. Emphasis and cursive text have been added.
Theory of inflation risk premia
“From an investor’s perspective, a bond that offers a nominal coupon payment of say 5% is more attractive when annual inflation turns out to be 1% rather than when it turns out to be 5%. Inflation risks are inherent in most investment strategies, and not surprisingly, investors commonly demand compensation for bearing those risks. The inflation risk premium is usually defined as the compensation demanded by investors to hold financial assets that are subject to inflation risks. Market-based measures of inflation expectations like the so-called break-even inflation rate…the difference between the sovereign inflation-linked bond yield and an equivalent sovereign nominal bond yield…and the inflation-linked swap rate do not only contain information on inflation expectations but also on the inflation risk premium.”
“In macroeconomic theory the stochastic discount factor [which translates future payoffs into present value] is equivalent to the marginal rate of substitution of consumption, or more precisely, the rate at which the investor is willing to substitute consumption today for consumption tomorrow…If we assume that the marginal utility of consumption is higher when the level of consumption is low, then an asset that provides low returns when wealth is most needed [i.e. when income and consumption are low] should be held by the investor only if it offers a positive premium.”
“Following this rationale, when the future movements of inflation are expected to be positively correlated with the future marginal utility of consumption, there is a positive premium for holding financial assets that offer nominal payoffs. This is so because the ‘real’ return on these assets deteriorates with inflation. To be more specific, in case market participants see the risk of ‘stagflation’, the inflation risk premium would be positive as investors like to hedge for high inflation that will ‘eat up’ real returns in the economic downturn. In contrast, the expectation of a deflationary recession could lead to a negative inflation risk premium as nominal bonds perform well in case of deflation.”
Methods for measuring inflation risk premia
“We construct model-free and model-based indicators for the inflation risk premium in the US and the euro area.
- [In] a model-free approach…we use quotes of the inflation-linked swap, and we replace the expectation of inflation…with available inflation forecasts from surveys like Consensus Economics. The inflation risk premium is thus the difference between the inflation swap quote and the survey inflation forecast.
- [In] a model-based approach…we formulate a model for the joint dynamics of the stochastic discount factor and the inflation process. The model will take the form of an affine term structure model for which the formulation of the risk neutral and the physical distributions are tractable, and we can proceed…to derive the inflation risk premium… To estimate the model we…assume that the pricing factors are the first three principle components of the inflation swap curve.”
“Zero-coupon inflation-linked swaps are the most commonly traded inflation derivatives in the euro area and the United States. One of the counterparts in the swap agreement will pay inflation and the other will pay an agreed fixed rate. The cash flow of the contract (for the net amount) will be paid at maturity. The agreed fixed rate is not, however, a perfect measure of inflation expectations as it includes an embedded inflation risk premium.”
Evidence for negative inflation risk premia
“Our results provide strong evidence, robust across business areas and measures for the inflation risk premium, that the inflation risk premium turned negative, on both sides of the Atlantic, during the post-Lehman period [and remained slightly negative or close to zero mostly thereafter]…The inflation risk premium [had been] positive in the period before the great recession… This is striking as most other premia, like credit risk premia, increased strongly amid the financial crisis.”
Causes of negative inflation risk premia
“We also find, and contrary to common beliefs, that indicators of inflation uncertainty alone cannot explain the movements in the inflation risk premium in the post-Lehman period….We use four indicators of inflation uncertainty…namely the implied volatility of long-term sovereign bond options…the monthly standard deviation of the daily changes in the one-year-ahead ILS computed with a one-month window…an estimate of the implied volatility measured from inflation options…[and] the difference between the mean and the median of the Consensus responses.”
“[These] indicators of inflation uncertainty…seem not to be the main driver of the inflation risk premium. What actually drives the inflation risk premium are indicators of inflation above the monetary policy target and indicators for deflation fears. The opposite sign of the indicators of inflation and deflation fears strongly indicates that the inflation risk premium is dominantly influenced by the balance of inflation risk rather than inflation volatility. This implies that a low, or even negative, inflation risk premium is primarily associated with strong deflation risk rather than low inflation uncertainty… The decline in the inflation risk premium seems mostly related to increased deflation fears and the belief that inflation will stay far away from the monetary policy target.”
“Nominal bonds are no longer an ‘inflation bet’ but have turned into ‘deflation hedges’.”
