Commentary on Political Economy

Wednesday 16 December 2020


Inflation is about to explode because liquidity is sky-high, working populations are shrinking, savings have risen and asset prices will crash as investors scramble for real inflation-proof stores of value. Central banks will be forced to raise interest rates and reduce bond purchases and governments will raise business and asset taxes. The yuan and the Ratland economy will blow up in a mushroom cloud. Global Stagflation looms.

Spectre of higher inflation threatens historic bond rally

As economies recover from the coronavirus shock, worries over inflation are returning © FT montage

Bond investors are braced for the risk that 2021 could herald the return of a long-dormant foe: inflation.

The price of government bonds has rocketed this year, largely because of the huge bond-buying programmes undertaken by central banks to soften the financial impact of the pandemic. Investors are assuming this support continues, even as economies pull out of their 2020 slump.

A rebound in inflation, which has been elusive since the 2008 financial crisis, could disrupt these widely held expectations by making the debt market look less attractive. Bonds typically provide investors with a fixed stream of interest payments, which become less valuable as the overall cost of goods and services accelerates.

If price pressure finally erupts, it would also ricochet through riskier assets. The 2020 rally in global equities has been powered by the rise in bond prices, which has pushed borrowing costs to historic lows and eased jitters over the widening gulf between stock prices and corporate profits.

“Inflation staying low and well-behaved is the foundation on which everything in markets is currently priced,” said Karen Ward, chief market strategist for Europe at JPMorgan Asset Management. “Investors’ assumption is that central banks will be able to stay accommodative well into the economic recovery. If inflation picks up in a way that’s not expected, that would challenge the market’s entire view.”

Line chart of Barclays Multiverse yield (%) showing Global borrowing costs have dropped to historic lows

Concerns about a potential inflationary burst are gathering pace particularly in the US, prompting some speculation that the Federal Reserve could be compelled to withdraw its support sooner than indicated.

The shift in market pricing is subtle but significant. In the eurozone, inflation expectations remain far below the ECB’s target of just below 2 per cent. But the 10-year US “break-even” rate — a proxy for investors’ expectations over the next decade — is rising. It has climbed from below 1.6 per cent in September to about 1.9 per cent, putting it at the highest since May 2019 and just below the Fed’s average inflation target of 2 per cent.

The chance of inflation skittering out of control is low, analysts said. With the pandemic causing unemployment to surge, it may be some time before workers are in a position to push for wage increases. And even once labour markets heal, the long-running demographic and technological shifts that many economists have said depressed inflation over the past decade remain in place.

BlackRock’s Bob Miller, who heads up its fundamental fixed income team for the Americas, is among those who worry that experience has left investors “complacent” about the prospect of consumer price increases in the coming year. And now, with bond yields sitting at depressed levels, the room for error is very limited.

“The market is a little bit hung up on the last decade's experience,” he said, adding that investors should buy assets that protect against inflation on a two to four-year time horizon.

Line chart of US 10-year break-even rate (%) showing US inflation expectations climb as investors await economic recovery

His argument rests on the pivot from the Fed earlier this year. The US central bank said in August it would tolerate higher levels of inflation to make up for the prolonged period in which consumer price increases have faltered below its target, a switch from its previous policy of pre-emptively raising interest rates to stymie inflation above 2 per cent.

Market participants reckon this means US interest rates, which exert a gravitational pull across all assets, will remain tethered to zero at least into 2023.

But once Covid-19 vaccines are widely distributed, businesses and consumers could unleash a jolt of pent-up activity. “The stars are aligning to put the economy on a pace for a robust recovery,” said Sonal Desai, chief investment officer at Franklin Templeton’s fixed income group. “That sets us up for definitely some inflation in the second half of next year.”

Investors are taking cover. Demand for Treasury inflation-protected securities has surged in recent weeks, with roughly $4.5bn poured into relevant funds since the beginning of November, according to EPFR.

The prospects of resurgent inflation already has investors seeking out alternatives to ultra-safe assets like Treasuries, sending prices lower and yields higher. Benchmark 10-year Treasury notes now yield about 0.9 per cent, having traded below 0.7 per cent less than three months ago. Analysts’ forecasts suggest they will hit 1.2 per cent by the end of next year, according to Bloomberg data.

Column chart of Weekly flows into US funds buying inflation-protected securities ($bn) showing Demand for inflation protection soars

Some investors question whether any pick-up in inflation would last, citing not only the scale of the coronavirus economic shock and the recent resurgence in cases, but also the failure of US policymakers to agree on additional fiscal support.

Steven Oh, global head of credit and fixed income at PineBridge Investments, thinks a likely rise in inflation in the spring should be fleeting and largely ignored by investors and central bankers alike.

Assuming central bankers will look the other way comes with considerable risks, however. Historically high prices of both bonds and stocks are premised on expectations of years of rock-bottom interest rates, and both could tumble if the Fed signals even a chance of higher borrowing costs, according to Shamik Dhar, chief economist at BNY Mellon Investment Management.

“That’s a world where fixed income stops being a hedge for equities, and both sell-off together,” he said. “That would be a big shock.”

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