Central banks welcome inflation – what does that mean for bonds?

Suddenly everyone's getting a bit worried about the bond bubble.

Yields on ten-year gilts British government IOUs have jumped above 1.1%. They're now at their highest level since just before the Brexit vote. Bond prices have fallen as a result (bond prices move inversely to yields).

Small wonder, you might think. After all, with sterling collapsing, inflation is set to rise. No one wants to be holding an asset that provides a fixed income when prices are going up, because that reduces the "real" value of said fixed income.

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It's a nice, logical theory.

Trouble is, it's not just Britain

Central bankers are looking for a bit of inflation

A central banker who's nonchalant about inflation; the prospect of rising import prices; a crashing currency no wonder UK gilt yields are rising.

However, as we noted above, this isn't just a "Brexit" thing. Many breathless pundits would like to present it as a just punishment for Britain's anti-European Union (EU) intransigence. But if you look at the reality, it's not that simple.

Yes, Britain is leading the way, but it's far from being the only one. As Bloomberg notes, "benchmark bond yields in Australia, Germany and the US climbed to their highest levels since June" on Friday.

Brexit does come into it. Britain's vote to leave the EU sent another spasm of risk aversion jolting across the financial markets. As a result, bond yields across the globe fell (ie bond prices rose) as investors sought out "safe" havens. (I put "safe" in inverted commas because "safe" suggests that you can't lose any money in these government bonds, which simply isn't remotely true.)

However, the world hasn't ended. As investors have woken up to that fact, they've moved back out of bonds, driving yields higher (and prices lower). The thing is, we're only back to where we were just before the Brexit vote.

So for global bond investors, this is more of a return to normal service, after a Brexit-inspired blip in the third quarter.

If you go back to June, investors were starting to wonder about inflation, what with the US nearing full employment and commodity and oil prices starting to recover.

And now, despite a growing belief that the US will raise interest rates again before the end of the year, it's also becoming clear that the US Federal Reserve has no desire to "get ahead of the curve".

On Friday, while Carney was saying he was happy to tolerate a bit of inflation in the UK, Fed chief Janet Yellen said pretty much the same thing about the US.

She's keen to let the US economy "run hot". (This is just central-bank speak for allowing inflation to take off). She reckons this could go some way to healing the damage caused by the Great Recession (as we're calling 2008 onwards these days).

If businesses are seeing sales boom beyond their production capacity, then they'll invest in order to produce more. If companies need to pay higher wages, they might tempt some of the long-term unemployed off the sidelines.

In short, she's got all her excuses lined up, and you should expect the Fed to allow inflation to rise. That doesn't mean there won't be any interest rate rises but it does mean that rates will rise more slowly than inflation does.

What happens when the bond bubble bursts?

It's one thing to ignore unreasonable market jitters when you've invested in a market based on its fundamentals. But if an asset class is crashing because investors have finally woken up to the fact that it's overpriced, then you can kiss goodbye to your bubble-based gains. They're not going to come back at least, not within a timeframe that will suit your pension pot.

So if the big bust comes, the best strategy is to take your losses and run. If you're going to panic, then panic early, as the saying goes.

(Of course, this relies on you understanding that you bought into a bubble asset in the first place, presumably on the basis that you'd be smart enough to sell out to a "greater fool" before the bust came. This is why it's vital that you record your reasons for investing in any asset at the point of purchase it increases your odds of salvaging something if everything goes pear-shaped.)

Anyway, getting back to the point no one wants to be invested in a bubble market when it bursts. And all of this is exacerbated right now by one thing liquidity, or the lack of it.

Liquidity sounds really jargon-y. But it's actually a pretty simple concept. It's simply a measure of how easy it is to buy or sell an asset.

Let's take the (somewhat inappropriate) metaphor of investors being like a crowd in a theatre. Someone shouts "fire!", and everyone runs for the exit. Liquidity tells you how wide that door is. If liquidity is healthy, the theatre empties quickly and in a relatively orderly manner. If liquidity is tight, you get a bottleneck, panic and bad things happen.

Liquidity in markets in general isn't great right now. And in the bond market, it's downright poor.

According to credit rating agency Fitch, reports the FT, "the risk of European mutual funds being unable to sell their underlying holdings in time to meet redemption requests has hit an all-time high".

In other words, people might rush to get out of bond funds, but be left unable to access their cash not unlike the problems seen with commercial property funds just after the Brexit vote.

When might this happen? Who knows? But what I'd suggest is taking a look at your portfolio and your allocation to bonds. If it's out of whack with where you think it should be (and this will depend on your own circumstances) then it might be a good idea to rebalance (ie take some profits on your bond allocation and put the money into something that hasn't done so well).

We'll have a lot more on this in a MoneyWeek issue on inflation in the next couple of weeks. If you're not already a subscriber, sign up now.