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.
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.
For more of PIMCO’s views on the complex drivers of inflation, please visit our inflation page.
Lorenzo Pagani is a managing director and a member of PIMCO’s global and real rates portfolio management teams. He is a contributor to the PIMCO Blog.