Government bond prices around the world dropped after Jerome Powell confirmed last week that the U.S. Federal Reserve Board was prepared to tolerate higher inflation as it steers the economy through the aftermath of the COVID-19 pandemic.
But while many investors say that talking about inflation is one thing, actually generating swifter price rises is another entirely. Unless the Fed can avoid a path trodden by the Bank of Japan and the European Central Bank – in which vast monetary stimulus has failed to nudge inflation back up to target levels – then a lasting reversal of the four-decade rally in fixed income is unlikely, they say.
“It’s all very well them saying this, but they have been trying to get inflation above 2 per cent since the global financial crisis, and it hasn’t been possible on a consistent basis despite strong economic growth, low unemployment, and massive stimulus,” says Jim Leaviss, chief investment officer of public fixed income at M&G Investments in London. “There’s quite a lot of skepticism that they can manage it now.”
Inflation is kryptonite to bonds, particularly longer-dated ones, as it erodes the real value of the fixed interest payments they provide over time. Analysts were quick to point the finger at Mr. Powell’s embrace of swifter price rises to explain a decline in bond prices.
The 10-year U.S. Treasury yield surged to its highest in almost three months, at 0.76 per cent, in the aftermath of the Fed’s policy shift last week, reflecting a drop in prices before retreating slightly. The 30-year yield climbed to more than 1.5 per cent at one point, up from about 1.2 per cent at the start of August.
However, on closer inspection, the moves were not driven mainly by inflation concerns. U.S. inflation-linked government bonds also fell. The 10-year break-even rate, which tracks the gap between nominal and real yields and serves as a proxy for investors’ inflation expectations, hovered around 1.77 per cent.
The relatively muted reaction is due in part to the fact that the Fed’s pivot was widely expected – investors have been pricing in higher inflation expectations for months as the economy rebounded and Fed policy-makers hinted that they would not be hasty in withdrawing stimulus. But in pricing in a decade of sub-target consumer price rises, investors are also expressing their doubts about the central bank’s ability to achieve its new average inflation goal.
U.S. inflation has only fleetingly run hot in the past decade. Since the Fed formally adopted a 2 per cent target in 2012, its preferred measure of inflation has exceeded this figure in just 16 of 102 months, according to strategists at Rabobank. Many fund managers are betting on more of the same.
“I do think that in some parts of the market there are worries about inflation, [given the] combination of rapid money growth, a large balance sheet, rapid debt growth, some concerns about globalization being short-circuited and starting to reverse, and broken supply chains putting upward pressure on prices,” says Nathan Sheets, chief economist at PGIM Fixed Income in New York and former under-secretary for international affairs at the U.S. Treasury. “But the post-global financial crisis period was one of low inflation in the U.S. and globally, and I expect that this next period will be very much the same.”
Investors are also informed by the experience of the eurozone and particularly Japan, where the central bank has grappled with persistently low inflation for decades despite aggressive efforts to generate growth. The deflationary effects of demographic change, particularly acute in Japan’s rapidly aging society, are increasingly being felt globally, according to investors.
Japan serves as a “Petri dish” for central bankers and their capacity to generate inflation through monetary policy, says Nick Maroutsos, global head of bonds at Janus Henderson in Longon. “We should look at its model and say, ‘Maybe we are not able to generate inflation.’”
Investors are likely to need more convincing that a lasting acceleration in consumer prices is on the way before the bond sell-off can continue.
“Ultimately, whether you think this is good or bad for bonds ultimately depends on your view about the potency of monetary policy,” says Karen Ward, a strategist at J.P. Morgan Asset Management in London. “Just because you say you want something, that doesn’t mean it will happen.”
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