It’s the end of the line for the bond market bonanza
They say one man’s meat tends to be another man’s poison, an idiom that sums up today’s fixed-income markets very adroitly. The last 10 years have been boom times for bond market players as global super-stimulus has dragged down interest rates and yields, but meant lean times for savers, pensioners and investors starved of decent fixed-income returns. The boot could be on the other foot in 2018.
Zero interest rates, quantitative easing and aggressive government debt buy-backs might have been manna from heaven for bond markets in the last decade, but the bonanza has deeper roots, going back to the early 1980s. Securitisation, fiscal tightening, a secular decline in interest rates and shifting investor preferences have driven a 35-year bond rally which is fast reaching the end of the line.
If we are lucky we will never see the likes of the last 10 years again in our lifetime. A close call with financial disaster, the blight of recession, debt deflation, fiscal austerity and punishing economic hardship have been the cornerstones of the bond rally as central banks pumped in boatloads of cheap and easy money to keep the global economy alive and kicking. But now the best of the bond bean feast is over.
Three factors will be weighing in favour of higher yields next year: central bank bond buy-backs on the wane, increasing government debt supply and the return of inflation. Yes, you read that right. The beast is back and faster-rising consumer prices should be the order of the day from now on. Maybe not in your neighbourhood right now, but inflation is gaining more than just a toehold in a number of economies, and central banks are quite rightly getting worried about it.
Back in 2008, central banks were forced into exceptional actions that they would never have imagined in their lifetime and the prospect of ultra-low, even negative interest rates and over-bloated balance sheets extending for too much longer has filled them with livid dread. Signs of stronger economic recovery and a glimmer of faster inflation have given them some hope of normalising policy before it is too late.
Ironically, we have lived so long with the threat of deflation since the 2008 financial crash that too-low inflation has become the norm and people are quite right to ask why it should do anything else. After all, commodity and energy price rises seem tame and a lot of the forward-looking inflation barometers seem fairly tepid. Market inflation proxies like the five-year forward inflation swaps in the US and Europe seem subdued even though are starting to creep higher.
Inflation may be down but it is not out. While deflation fears may be keeping conventional inflation expectations under wraps in the real economy, inflation is simply manifesting itself in other ways, especially in faster asset price rises. The explosive gains in stock markets in the last few years and booming house prices are simply other forms of inflation forces letting rip.
Central banks know this all too well and for the US Federal Reserve, Germany’s ultra-hawkish Bundesbank and Britain’s Bank of England enough is enough. It is why the argument has turned quite decisively to tighter policy in the medium term to get interest rates closer to sustainable, non-inflationary levels in the 3 to 4 per cent bracket before higher inflation gets a stronger foothold.
Britain is already in the grip of a mini-inflation crisis, which could easily turn into the central bankers’ worst nightmare of stagflation – weakening growth coupled with faster price rises. Headline inflation has already hit 3.1 per cent thanks to the weaker pound, under-investment, poor productivity and unrelenting utility price rises. The UK may be in the vanguard but is no special exception to the rule.
In the longer term, inflation is going up. Deflation forces might have kept price pressures suppressed for a while, but policymakers have tugged on the policy elastic for so long with super-stimulus that the inflation brick is about to hit markets squarely in the face. It’s only a matter of time. Super-stimulus has overstayed its welcome.
Global growth is fighting back, inflation pressures are picking up and interest rates and bond yields will continue to adjust higher. The good times are over and bond investors should buckle up for a rocky ride in 2018.