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Inflation fears are not unfounded but a nightmare scenario is unlikely
- True, an inflation spike and sharply higher bond yields would derail markets. But this is unlikely given the slack in the economy and central bankers’ reluctance to unwind easy policy
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Kerry Craig, executive director, is a global market strategist at JP Morgan Asset Management, based in Melbourne.
The prevailing mood in the markets is cautious optimism, with a near-universal expectation of economic rebound on the horizon. Much less agreed on, in fact quite hotly debated, are the dangers that may lurk from inflation.
High inflation, or even just moderately higher inflation at the wrong time, could upset investor sentiment and drag down equity and credit markets.
Inflation, or rising prices in the economy, matters because it is reflected in both the price and yield of government bonds, the so-called risk-free assets which are the starting point for judging the attractiveness and risk-reward trade-off of other assets.
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Any build-up of inflation expectations would lead to rising bond yields and falling bond prices. This is because rising inflation erodes the value of bonds and makes their coupons less appealing, especially longer-dated ones.
Recently, yields on government bonds have been very low, and prices have been so high that investors have mostly shunned government debt for better priced equities. However, a faster improvement in the inflation outlook and higher bond yields could lead to a reversal in this trend as investors see an opportunity to pick up cheaper government bonds.
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