How high will European inflation be in the next ten years? 2-3%? Is inflation the only way out from this financial mess? With Italian bonds you can pay 0.7% and receive inflation for ten years and here is why.
The ten year benchmark (3 3/4 08/21) has a yield to maturity of 4.9%. The 10 year inflation linked brother (2.1 08/21) has a real yield of 4.2%. Therefore the market is pricing ten year inflation at only 0.7%!
Let’s validate this by looking at their German cousins. The closest inflation linked bond is the 1 3/4 4/20, with his nominal brother being the 2 1/4 09/20. Their yield is 0.2% and 1.8% respectively, so they are pricing an inflation at around 1.6%. Both the Italian and the German Bonds are linked to the same European inflation index, so who is right? Let’s dig further into this. Also France has inflation linked bonds, the 2 1/4 7/20 and the 2 1/2 10/20 are pricing an inflation at around 1.7%, so in line with the Germans. Looks like the Italian one is mispricing inflation. Let’s also look at the historical implied inflation (yield spread) in the Italian pair.
You can see that the spread sharply decreased at the beginning of August. Why? Simple, the ECB is buying the nominal ten year benchmark but not the inflation linked and this is causing a distortion in the market.
And here is the same spread chart on the Germans and French.
Click to enlarge
Click to enlarge
- Long Inflation at 0.7%
Long the 2021 inflation linked and short the 2021 nominal, no credit risk and long inflation at an amazingly low level.
- Inflation arbitrage
Buying inflation in Italy and selling it in Germany. Long the Italian 2021 inflation linked and short the 2021 nominal, at the same time short the German 2020 inflation linked and long the 2020 nominal.
Disclosure: I am long the italian 2021 inflation linked bond.