By Yoruk Bahceli

(Reuters] Market-based inflation gauges are turning red because of the threat to increase energy prices in Ukraine. This is prompting investors to invest in inflation-linked bonds to protect themselves from the rising costs.

Russia’s invasion of Ukraine has raised energy supplies concerns to the tune of $105 per barrel. European gas prices have increased 50%-60% from last week.

Although government bonds are safe havens, rising energy prices have led to bigger gains for European and U.S. inflation-linked debts, securities whose face and interest rates rise with inflation.

Paul Rayner from Royal London Asset Management, Head of Alpha Strategies said that UK inflation was very competitive at the front end. This is a reflection of the front contract of the.

The yields of British 1-year inflation-linked bonds, or linkers, have dropped 80 basis points in the past week. They are now below -7 percent and were once implying an inflation rate above 9%.

Prices are inversely affected by bond yields.

The Bank of England predicted that inflation would reach a peak of around 7.25 percent in April, when an increase of 54% in household energy bills will take effect.

A related graphic: UK inflation-linked gilt and gas price: https://fingfx.thomsonreuters.com/gfx/mkt/gkplgaxodvb/uk%20linker%20and%20gas%20price.png

Germany is the largest consumer of Russian gas. The two-year inflation adjusted yield, which excludes anticipated inflation, fell 60 basis points from the beginning of last week. This implied an inflation rate of 3.7% as compared with 2.4% at February’s start.

The U.S. has a smaller move, with yields for one-year Treasury Inflation Protected Securitiess (TIPS), down about 20 bps.

These falls partially reverse an increase seen at the start of this year. Expectations of tighter central banks policy fueled a selloff, and U.S.- and German 10-year real yields rose by 70 bps & 40 bps each early February.

TIPS saw their first inflows for five weeks during the week from February 23rd to March 23, BofA reported, citing EPFR data.

Some warn that linkers may distort inflation rates through factors such liquidity, central bank purchases, and, in Britain, large pension fund demand.

However, record-high inflation could be exacerbated by rising energy prices Deutsche Bank (DE) Gas prices expected to rise by 50% in 2020 and oil prices 20 percent in 2022. That would make the European Union’s inflation rate 5.7%, which is one percentage point more than predicted without Russia-Ukraine conflict.

The European Commission predicted that growth would be 2.8% in 2022, which is well below the forecasted 4%.

Chief economist at the European Central Bank has told policymakers that conflict could reduce output by between 0.3% and 0.4% in a “middle situation”.

Patrick Krizan from Allianz, Munich senior economist said “Stagflation has become clearer.”

Fear of a recession could cause central banks to slow down their shift towards tighter post pandemic monetary policies. While the Bank of England may reduce its rate increase, the ECB might delay making any firm promises.

Krizan, Allianz: “What’s fascinating about inflation-linked bond… is that you get exposure at both the inflation risk as well as a safety-haven asset so it seems doubly attractive.”

A related graphic: German, UK breakevens: https://fingfx.thomsonreuters.com/gfx/mkt/zdpxokrzqvx/uk%20germany%20breakeven.png