There’s never a more critical time to understand inflation and fixed income markets

Inflation is at a 40-year high. With the long tail of Covid-19 squeezing supply chains and the war in Ukraine and the crisis in the Middle East driving up the cost of energy in Europe, central banks are grappling with a global pressure on prices that hasn’t been seen since the 1970s. The Fed, the Bank of England and the ECB have all tightened monetary policy and raised interest rates – in some cases by record margins – to rein inflation in, while still hoping to engineer a soft landing for the economy. But how do these interventions impact financial markets –especially bond markets that are highly susceptible to changes in interest rates? And what does it all mean for investors?

LSE’s Martin Oehmke, Professor of Finance, has a long-held research interest in bond markets and financial regulation. He leads LSE’s course for executives, Fixed Income: Markets, Securities and Institutions, which he describes as a “fast track” for business leaders and decision-makers looking to get a steer on how to navigate bond markets, particularly in these times of volatility.

“Financial markets all over the world are impacted by rising interest rates and the big valuation changes that are happening right now. Stock markets are down, and bond markets have experienced their worst year in a generation. Bonds and other fixed-income instruments are especially affected by changing interest rates, since rising rates typically mean falling prices,” says Oehmke. “This affects everyone. For companies, pension funds, asset managers, and individuals with investments in fixed income markets, it is imperative to understand what is going on and to develop tools to map out what’s ahead.”

The Fixed Income course delivers these tools, says Oehmke. In addition to a hands-on valuation framework for bonds and other fixed-income instruments, the course develops an advanced toolkit for extracting information from financial markets and conveys the institutional knowledge required to understand how key players, such as central banks think. These are practical tools, he adds, that can help consolidate a longer-term investment strategy.

For example, the course explores a concept called duration, which summarises a bond’s exposure to interest-rate risk. Higher duration means that the value of an asset is more sensitive to changes in interest rates. This tool allows investors to determine which of their investments are particularly affected by further interest rate increases and how to hedge the resulting risk exposure.

“Duration is really key to figuring out what’s going to happen to the value of your investment,” says Oehmke. “But savvy investors will also want to know more about how things are likely to pan out in the broader context, and what markets might do in response. They’ll want to use that information to forecast and to make better, more strategic decisions for themselves or their business.”

One example of Oehmke’s advanced toolkit is the use of bond prices and derivative markets to gauge inflation expectations and expected interest rates.

“When you’re creating your investment strategy in volatile times, you are not just going to want to know which investments to hedge; you’re also going to want to know what the market is currently expecting and do some scenario planning around market reactions. If your view is different from the market view, you can use that information to decide how you’re going to trade.”

This is where concepts like “breakeven inflation” come in. Breakeven inflation is calculated by comparing yields of regular bonds and their inflation-protected counterparts. This allows investors to determine how much inflation the market is currently pricing in.

Derivative prices contain even more information. “People often think of derivatives as highly mathematical instruments for specialists. But derivative prices contain information relevant to everyone, and harnessing this information is actually straightforward and practicable. We look at option prices to figure out what probability the market attaches to certain scenarios. For example, how likely is an “inflation disaster” in which long-term inflation remains stubbornly above 5%?” says Oehmke.

Forecasting the coming inflation storm and benchmarking against what the market thinks will stand you in good stead. But there’s another element to navigating market volatility, Oehmke notes; and it’s this element that really influences interest rates.

“Central banks are the lynchpin. It’s all very well to assemble the valuation tools, but unless you understand what the Fed, the Bank of England or the European Central Bank are likely to do, you’re only going to see half the picture. ”

For this reason, the course digs deep into monetary policy, and the objectives and thought process that undergird the decisions taken by central banks – the key institutions that are shaping this changing environment.

“Typically when inflation spikes, there’s a lot of speculation or second-guessing around central banks, how quickly they will raise rates, and for how long rates are likely to remain elevated. We make it a real priority to dig into the institutional factors at play to get the big picture. From there, it’s much easier to determine what the best course of action in any scenario will be.”