Recent UK consumer price index (CPI) data showed shopping baskets are getting more expensive. That’s bad for consumers on a budget and for investors it reflects one of 2021’s stand-out themes: after a long absence, inflation is back.
The behaviour of bond markets in the face of this threat is one of the main determinants of returns for all asset classes, this year and beyond.
Sovereign government bonds from issuers with stable economies and currencies are considered free of default risk, but there is still volatility. Future cash flows from bonds are fixed, comprising regular coupon payments (the interest from a bond) and the redemption of the principal sum lent to the issuer.
Freshly issued ‘on the run’ bonds pay coupons that reflect the current market yield as a percentage of the ‘par value’ of the bond. Already issued ‘off the run’ bonds fluctuate in value to give the market yield, which is why investors can sustain capital losses, even on safe government debt.
Inflation contributes to volatility in bond markets because it decreases real yields and also investors fear the response of central banks. Last week the United States Federal Reserve signalled it planned to start tightening interest rates in 2023, a year earlier than previously thought.
Central banks manage inflation by raising interest rates. But when this tightening of monetary policy occurs, the market rate of interest must go up and off the run bonds sell off. As yields rise this has a knock-on effect for other asset classes, which must fall in price to stay attractive relative to the ‘risk-free’ yield on safe government bonds.
The market for sovereign bonds, especially US Treasuries, is something of a cat and mouse game between investors and policymakers. On the one hand, investors don’t want to see interest rates tightened too fast. On the other hand, they want a real yield that rewards them for tying up their money with the government.
More hawkish noises from the Federal Open Market Committee (FOMC) was a signal that inflation won’t be tolerated to the extent that investors had thought earlier in the year.
The fact that US 10-year Treasury yields drifted slightly lower after another month of rising CPI data for May suggests investors are buying into the Fed’s long-term target of inflation running at just above 2 per cent.
Much will hinge on how much of President Biden’s proposed $6tn stimulus package gets passed and how mooted tax increases to partially pay for it affect investment in the economy.
Although expectations are clearly for higher inflation, they appear to be anchored. The fact there is no assumption that Biden’s monumental plans will be paid for solely by printing money should be reassuring, especially if the Fed’s $120bn-a-month quantitative easing (QE) programme is tapered before the end of this year.
“With QE tapering on the horizon for year-end and the Fed suggesting rates hikes are moved forward, it is hard to think that real yields will go much lower from here”, says Chris Iggo, chief investment officer at AXA Investment Managers.
The scene is set for rate rises to occur in 2023 and possibly as early as 2022, which means real yields will rise but in a well-telegraphed manner. That's good for growth and probably favours growth stocks.
