In the late 1970s inflation in the US was well into double figures and prompted Ronald Reagan to declare that “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”. Interest rates were also uncomfortably into double figures and this unhappy state of affairs continued until the early 1980s when Paul Volcker Jnr, Chairman of the Federal Reserve Bank of America, decided to kill the inflation dragon by squeezing the money supply.
He succeeded brilliantly and set the US on a course of disinflation that has been broadly sustained over the last 37 years. This has allowed interest rates to fall resulting in capital gains for all financial assets. Indeed, the change in the “risk-free” rate is the most important factor in determining bond returns, the price earnings ratio of equities and the capitalisation value of rents from property.
30 years ago, Alan Greenspan was appointed chairman of the Federal Reserve when deflationary forces were beginning to emerge. Oil prices had been falling, and, more importantly, the emergence of Chinese exports led to a sustained fall in the price of goods and the expansion of world trade. That force kept inflation at close to target levels even as Central Banks were persistently accommodative. Greenspan and his successors loosened monetary policy readily in anticipation of real or imaginary problems but tightened only tentatively when the economy overheated. Inflation was contained and the Federal Reserve concentrated on the second part of its mandate, to stimulate economic growth. The concern of this approach was it that it ignored the increase in debt. For Greenspan it was an act of faith that the private sector would naturally avoid excessive risk. The financial crisis of 2008 proved otherwise.
If debt was the problem, then more debt has been the solution. The financial crisis led to unprecedented monetary experimentation. Quantitative Easing (QE) became widespread and some banks even introduced negative interest rates.
And so, over a period of 30 years, with only a few blips along the way, bond yields have trended steadily downward, primarily because inflation, and the expectation of future inflation, have been squeezed out of the system. This fall in bond yields is best illustrated by the fact that amid the gloom and stagflation of 1981, yields on 10-year US Treasuries were 16% per annum falling to a low of less than 1.4% in June 2016. Falling yields translate into an increase in the value of the underlying security and so Investors have experienced a bull market in Bonds for more than 30 years with values rising exponentially.
Lower yields mean cheaper lending and borrowing rates. They justify a lower yield on equities helping to push up the value of stocks and shares. Unfortunately, however, low yields also make life difficult for savers—particularly those running pension funds—as guaranteed future income gets more expensive.
But now, according to some financial commentators, the bull market in bonds may be coming to an end. The yield on 10-year Treasuries is now more than 2.8%, up from 1.36% in less than 2 years. This uptick in yields may signal a change in trend but if yields grind slowly upwards, economies and financial markets have nothing to fear. The danger will come if we have a sudden spike in inflation causing bond yields to rise too far, too quickly and Central Banks tighten monetary policy by raising interest rates too aggressively. This would have serious implications for the world economy and for asset prices. A serious correction in bond, equities and property prices would likely follow.
The recent up-tick in yields is, however, only a rise of not much more than a percentage point to a level that is still not very high compared to the historical average. The rise in bond yields does not, yet, change very much but what many financial commentators fear is that if it becomes clear yields are in an upward trend, they might rise very sharply. That could create a domino reaction throughout the system. With the world economy in good shape a sudden, painful rise in bond yields, is by far, along with geo-political risk and the possibility of Central Bank policy error, the greatest risk on the horizon.
But is it going to happen? Inflation is the most important factor in determining bond yields and if inflation remains subdued, bond yields will not rise very far or very fast. The forces pushing down on bond yields and inflation are strong. Central Banks, notably in China and Japan, keep their currency reserves in US Treasury debt. They buy bonds as a deliberate way to keep yields down. Populations are ageing and need to buy more bonds and Government regulations force many Institutions, most notably pension funds, to buy bonds keeping yields low.
The case to fear future inflation may well rest on the long-term recovery in the US labor market. This could raise the bargaining power of workers and could lead to higher wages. The working man could derail the world economy if wages rise too far, too fast. For now, though, this does not seem likely because there is still spare capacity in the system and although unemployment is low, there are large numbers who are not even looking for work. This large potential workforce could yet deploy itself if the economy grows as expected, and stop wages rising too far, too quickly.
The world economy is currently enjoying a “Goldilocks” phase with growth that is not too hot to fan the flames of inflation but also not too cold to damage corporate profitability. Wage inflation could bring this benign economic environment to an end and the recent payroll statistics in the US which confirmed a 2.9 per cent year on year rise in average hourly earnings has spooked financial markets. However, this rise could be a statistical blip because of seasonal adjustments and may not yet signal a worrying change in trend.
Only time will tell. In the meantime, Clarion Wealth will be monitoring the situation carefully so that our Portfolio Funds and Model Portfolios can be adjusted if we suspect that inflation is coming uncorked and the inflation Dragon is about to make a comeback.
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