This is an unusual blog for me - it deals with my views of the current state of play with inflation and bond markets.
Recent statistical releases as well as the prognostications of countless talking heads have raised the spectre of inflation once more. Commentators are hanging, with bated breath, on the words of monetary policy officials.
The strength of the economic rebound from the pandemic lows has surprised many. Growth forecasts have been progressively raised. For the UK, the OECD is, at the time of writing, forecasting UK growth of 7.1% versus 4.2% last December. This could be regarded as a vindication of the role of Keynesian fiscal policy allied with Central Bank accommodation and the low cost of debt financing.
The high levels of inflation seen in the spring and early summer are in large part a statistical artefact, reflecting last year’s entry into lockdown. The question is whether this will prevail in the long term. In the near term, wage inflation is unlikely to drive inflation, other than perhaps in the hospitality industry, until full employment returns. The output gap is still large, with GDP per capita at £28,000, it is well below the pre-pandemic projection of £40,000.
Central bank objectives are now mixed; they are prepared to tolerate higher inflation in pursuit of growth in the short-term. Longer term, we may expect their policy interventions to lag developments in the real economy, notably inflation. Recent high inflation releases, as well as the hawkish utterances of the Federal Reserve Chair, Jay Powell, have resulted in rises in short-term government bond yields[i] but falls in long-term rates. It appears that the view that this inflation increase is transient is in the ascendency. Market derived ‘breakeven’ rates are firmly anchored in the region of 2%.
However, there are sound reasons for this view to be troubling in the medium and long term. China and the large-scale exporting of consumer goods will no longer be a significant deflationary factor in the world economy; with a strong renminbi it could even be exporting inflation. The larger technology companies have ceased to be disruptors and are now monopolists. In the UK, Brexit will add to the political shift in favour of labour, though in the US it appears that the Supreme Court is set to resist this trend. The overarching long-term reason lies in the demographics and is expounded at length in Charles Goodhart and Manoj Pradhan’s book The Great Demographic Reversal. Ageing populations in Asia and the West mean more consumers and fewer producers, an inflationary mix, and the end of the benign environment which has prevailed for the past thirty years.
This is no re-run of the rampant inflation of the 1970s, though it should be noted that there are few market participants with experience of those times, and it will be politically expedient as a means of managing down, in real terms, the mountainous debts created by recent pandemic support measures.
Conventional bonds will lose purchasing power, longer duration issues particularly so. High convexity will again be considered a positive attribute of a debt security. The break-even rate will again be the most relevant market value indicator.
Inflation-linked gilts are currently priced to return RPI less two to three hundred basis points and with the shift of the basis of RPI calculation to CPIH is 2030 are unlikely offer any real respite in that regard.
The yield curve can be expected to rise and to steepen from short-dated to long. Expected annual returns are negative for at least five years. Corporate bond spreads can be expected to widen. The most pronounced widening is likely to be in the debt of capital-light, intangible-heavy technology companies, and may be exacerbated by regulatory interventions on taxation and competition.
While long-only speculators may desert the bond markets, there are many participants who will remain. Insurance companies and pension funds buy bonds to hedge their liabilities and, absent a shift in their risk preferences which would entail a need for higher equity capital financing, are unlikely to stop. For DB pension funds, with the Pensions Regulator’s new emphasis on higher and more conservative funding, contained in their prospective DB Funding Code, we may even see increased purchases.
Banks of course will continue to hold bonds to satisfy regulatory requirements. Primary dealers and other ‘carry-trade’ investors such as hedge funds are also likely to be present, as are investors rebalancing portfolios to strategic allocations. For this latter group, the key is diversification and the correlation between equity and bond returns.
Finally, and perhaps most uncertainly, central banks may continue their bond buying; they are most keen to avoid any repeat of the ‘taper tantrums’ which arose in response to proposed decreased activity. All in all, it seems that the decline in prices and increases in yield will be a slow process taking place over intermediate timescales – five years and more may be a good guide.
New government issuance will tend to decrease once austerity is pursued, and refinancing activities are likely then to dominate their official debt management activities. Against a background of strong growth, corporate borrowing demands are likely to remain high. It is likely that much of this debt will be destined to finance their climate change transitions.
Floating rate notes can be expected to see a resurgence in popularity, particularly when interest rate swap terms are favourable. We may even see the issuance of inflation linked securities by private sector bodies to finance infrastructure developments and other utilities, and perhaps even to finance residential property.
One thing is certain, we have reached the end of the forty-year secular decline in bond yields.
[i] The US market-implied probability of two rate rises in 2022 is now 50%.