Macro
If bond yields were the litmus test it would be easy to believe that inflation in most countries is at zero or below. Bonds should provide investors with a real return from the income yield, but this is not the case. The graph highlights the steady downward trend in benchmark 10-year yields over the last 25 years.
Benchmark 10-year government bond yields
Source: Thomson Reuters Datastream
Of the six countries in the graph only the US and Canada have a positive gap between the 10-year bond yield and the most recent annual rate of inflation – but it is a tiny one and well below historic norms. In Germany the latest annual inflation rate is a positive 2.1% yet the 10-year bond yield is negative!
In the UK the real bond yield has been negative for a significant chunk of the last decade. The last time this occurred was when inflation was rocketing in the 1970s through to the early 1980s. In that era 10-year bond yields reached as high as 16% whilst inflation was even higher. The contrast with today couldn’t be greater.
UK Real Bond Yields
(10 year bond yields minus the RPI)
Source: Thomson Reuters Datastream
So, what is going on? Either inflation is expected to collapse, or a new order has been established – one in which investors no longer expect to generate a real rate of return from the income component of bond investing. We somehow doubt the latter based upon our contacts with investors around the world but, equally, a total collapse of inflation suggests a dramatic slump in the already feeble rates of economic growth.
The problem is that central banks have manipulated interest rates to these crazily low figures and investors have followed them down. Now they have a problem. From this level returns are going to be tiny or negative but that is not the basis on which the investment world operates. Insurance companies, pension funds, bond funds, investment managers, savers and all the rest are operating on the expectation of real returns. Budgets are prepared on the basis of real returns. Actuarial forecasts are based on the premise of real returns.
Could inflation collapse? For many years central banks and others employed the concept of the Phillips Curve to assist in inflation forecasting. In simple terms this drew a link between levels of employment and wage growth and, by implication, inflation. If this was applicable today wage growth and inflation in the advanced world should be robust as average unemployment levels are generally low.
It seems, therefore, that the link, if indeed there ever was one, has broken down. Our view is that the economic “recovery” since the global financial crisis has been tenuous – based on lashings of artificially cheap money and the forced improvement in financial markets – not the genuine private-sector return to confidence that has typified the years following recessions over the last 50 or 60 years. We have previously reported that this “recovery” has been the weakest based on all the traditional measures – GDP growth, consumption, employment, labour productivity and investment.
The last time inflation in much of the world fell below zero was during the financial crisis. Demand collapsed along with trade, employment and the financial markets. In the US the annual rate of inflation fell as low as -2.1% in 2009 before recovering as quantitative easing began to bite. The previous dip below zero was in 1955.
The relatively anaemic shape of world demand and growth and, to use our term again, the tenuous nature of the recovery, suggests to us that inflation could again slip below zero. The other factor is debt. Once again, the world has far too much of it and a classic form of debt deflation could occur. Central banks will fight it tooth and nail, but they don’t have the firepower of a decade ago. Their balance sheets are now bloated, and official interest rates are already very low (negative in several countries and falling in others).
Conclusion
A bond yield of zero doesn’t look so bad if inflation is -2%, although putting your money under the mattress would yield the same return. If we were betting people, we would give this scenario a 50:50 chance over the next few years. But, by definition, that means we believe there is a 50% chance of inflation rising from current levels. Either prospect is not particularly inviting.
This wire is an extract from the 2019 Q2 edition of Pyrford's 'Pyrspectives'
Protect your portfolio on the downside
Pyrford seeks to provide a stable stream of real returns over the long term with low absolute volatility and significant downside protection. To find out more, please visit our website