1 February 2018
Inflation and bond yields – some context
But first some context. In a big picture sense, inflation has been falling since the mid 1970s-early 1980sThe global economy is finally emerging from its post-Global Financial Crisis (GFC) hangover. Talk of secular stagnation was overdone. Slow global growth since the GFC largely reflected a typical constrained aftermath from a major financial crisis.
Source: Global Financial Data, AMP Capital
The fall in inflation over the last 30-40 years reflects: the inflation-fighting policies of central banks; supply side reforms that boosted productivity; globalisation that brought a billion or so workers into the capitalist system; and the benefits of the information technology revolution harnessed by the likes of Amazon and Uber. The fall in inflation in turn has been the main driver of a super cycle bull market in bonds, with yields trending down since the early 1980s. (Don’t forget, when bond yields fall, bond prices rise. Suppose the government issues a $100 bond paying $4 pa in interest for an initial yield of 4%. If investors push yields down to 3%, the bond’s price will be pushed up until the 3% yield is achieved with the $4 interest payment.)
The 35-40-year fall in inflation and bond yields has also underpinned strong gains in most other assets. Put simply:
- the shift to lower in inflation allowed interest rates to fall;
- this allowed bond yields to fall (resulting in capital gains);
- which in turn allowed shares to be rerated higher (price to earnings multiples rose from around seven or eight times in the early 1980s to around 15-17 times), which boosted share returns over and above what would have been expected from dividend yields and earnings growth alone;
- lower interest rates allowed other assets to trade on lower yields boosting both commercial property returns, house prices and infrastructure returns. In particular, residential property gained as lower mortgage rates allowed people to borrow more relative to their incomes.
Inflation starting to stir globally, bond yields on the up
Since late 2016, our assessment has been that the super cycle bull market in bonds is over. This remains the case for several reasons. First, deflation risks are receding and gradually giving rise to inflation risks, led by the US:
- Global growth is now starting to run above potential again and this is leading to a decline in spare capacity and with global growth now accelerating this is likely to have been used up by late next year. Diminishing spare capacity makes it easier for companies to raise prices.
Source: Bloomberg, AMP Capital
Thirdly, bonds remain over loved with a huge post-GFC inflow into bond funds in the US. (The same picture applies if ETFs are added in.) This leaves them vulnerable to a reversal if investor sentiment towards them turns really negative.
- Historically, bond yields have remained low after a long-term downswing for around several years as it takes a while for growth and inflation expectations to really turn back up. See the circled areas for US and Australian bond yields in the second chart in this note.
- While the Fed is likely to raise interest rates more than currently expected by the US money market (we expect four hikes and the market is factoring in two or three), the process of rate hikes is still likely to remain gradual.
- Central banks in Europe, Japan and Australia remain a fair way off starting to tighten so global monetary policy will remain easy for a while yet.
- Global inflation is unlikely to take off too quickly given spare capacity in labour markets (in Europe and Australia) and technological innovation continuing to constrain inflation.
- Inflation expectations are anchored at low levels far better than was the case in, say, 1994.
- Finally, the idea that high debt levels mean that central banks will either have to live with a debt crisis or much higher inflation is nonsense. High debt levels just mean that interest rate increases are more potent than they used to be – so when inflation does start to become an issue, they won’t have to raise interest rates as much to bring spending and inflation back under control than was the case in the past. In fact, high debt levels mean central banks have more power than in the past to control inflation.
Implications for investors?
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