Mispricing in inflation markets

We use UK transaction-level data on nominal bond, inflation-linked bond and inflation swap markets to study trading behaviour and prices in inflation markets. Our empirical analysis yields five main results: (i) there is persistent inflation mispricing over the 2018–22 period, with nominal gilts on average 135 basis points more expensive (per £100 notional) than their synthetic counterparts constructed from inflation swaps and inflation-linked bonds; (ii) hedge funds respond to changes in mispricing but their response does not constitute arbitrage – they adjust their bond portfolios appropriately, but do not hedge these trades in the inflation swap market; (iii) inflation markets are largely segmented with liability-driven investors and pension funds (LDI-P) dominating the inflation swap market, and many clients that are active in bond markets are absent in the inflation swap market; (iv) LDI-P activity is a key driver of inflation mispricing – the sector’s orderflows in inflation-linked bonds and (to lesser extent) nominal bonds and inflation swaps contribute significantly to day-to-day variations in mispricing; (v) the generally weak link between market-based measures of inflation expectations and survey-based measures is strengthened once we clean market prices from the effect of LDI-P trading activity.