Do you own long-term bonds? You might want to think about selling

Janet Yellen © Getty Images
Janet Yellen says she’ll let the US economy run hot. Big investors are starting to believe her.

I know I’ve been carping on about inflation a lot over the last few Money Mornings.

I’m going to do it again this morning. If you’re getting bored, do let me know. But I think it’s an important topic.

You don’t often see epochal shifts in markets. If we really are finally throwing off deflation, then it could be the start of something huge.

Particularly if you’re the unlucky holder of government debt that won’t mature for another 50-odd years or more…

The wonderful world of bond market jargon

“Duration risk”. There’s a term to strike fear into the hearts of anyone who reads or writes about financial markets.

It’s not that tricky though. “Duration” is a measure of how sensitive a bond’s price is to changes in interest rates.

A bond pays you a fixed income. If interest rates go down, that fixed income doesn’t change. As a result, it becomes more valuable compared to the income that can be found elsewhere. So investors are willing to pay more for the bond.

If rates go up, the fixed income loses value. So investors pay less for the bond, and its price goes down.

Got that? Great. Next step.

If you own a bond that pays you back your money (matures) in six months’ time, then a move in interest rates won’t affect the price either way that much – you’re about to get paid after all.

But if your bond doesn’t pay back for another 50 years – that’s different. It’s a long time before you get your money back. Any shift in interest rates makes a big difference to the relative appeal of locking in a fixed payment for that length of time.

So the longer a bond has to go before maturing, the greater its duration risk.

And that’s becoming a big thing now.

You see, as Bloomberg reports, the amount of government bonds with maturities of more than ten years in issue has hit a record $6trn this year. That’s more than doubled since 2009. And in 2016, issuance also hit a record – $733bn so far.

Investors have piled into long-term bonds, fixated on getting a half-decent yield. That’s created a market for more than just 30-year US government bonds.

Ireland, Italy and Thailand each have 50-year bonds outstanding. Argentina and Brazil – countries with histories of hyperinflation and default within living memory of anyone over the age of about 25 – have borrowed for 30 years. Belgium has issued 100-year debt.

The problem is that all of that debt has massive duration risk. For now, investors have bought for the yield. But if interest rates or inflation pick up, they’ll get stung by the duration risk.

Does anyone buy a Belgian bond planning to hold it for 100 years? Don’t think so. So if and when rates rise, and the capital value of the bond drops like a stone, it won’t be a matter of shuffling it to the back of the portfolio. It’ll be full-blown sauve qui peut! situation.

And with yields picking back up in bond markets globally, it looks like we could be seeing the start of that now.

This is exactly what central bankers wanted

This all sounds rather worrying. But it’s also worth remembering that this is what central bankers wanted. Let’s have a quick refresher course here.

In the normal course of things, central bankers treat the interest rate as a way to control the economic engine. If the economy runs too slowly, the central bank cuts interest rates. That pushes more credit into the system, and it all picks up again. If it runs too quickly – as indicated by rising inflation – the central bank raises interest rates, slows down the rate of money creation, and the economy slows.

That’s a very simplistic model, which takes little account of human behaviour. That’s why it hasn’t worked very well. But that’s a discussion for another time and place (preferably somewhere serving alcohol).

Anyway, the problem with using interest rates as an accelerator pedal is this: what happens if you put your foot to the floor and the engine is still chugging away?

That’s why when interest rates hit zero, or thereabouts, central bankers panic. It’s called the “zero lower bound”. The fear is (or was) that when you get to 0%, you can’t cut interest rates any further, and so you can’t force people to go out and spend and take huge risks in the asset markets in the hope of eking out some sort of return.

Since then – as always – theory has proved to be different to reality. It turns out that you can cut rates below 0% by at least a bit, because most people can’t be bothered with the inconvenience and risk of storing large quantities of physical bank notes.

(That’s also why central banks want to reduce cash in circulation, starting with large-denomination notes – they more inconvenient it is to hold cash, the further you can push interest rates into negative territory before people start hoarding.)

But clearly it’s not ideal to get to a world where negative interest rates are just the way of things. So what central bankers really want to do is to get people to fear the return of inflation.

Central bank policy when rates are at 0%: convince them you’re crazy

Economist Paul Krugman – a man central bankers most definitely pay attention to ­– has argued on several occasions that when interest rates get as low as they are today, one way for central banks to maintain some sort of influence over the economy is to “convince the public that it will pursue a more inflationary policy than previously expected after the economy recovers”.

Even if inflation doesn’t exist today, the idea that prices will rise tomorrow might get people to go out and spend now. This is the whole point of “forward guidance”, various arguments for higher inflation targets, and talk of “nominal GDP targeting” – all of those are designed to convince markets that central banks will “do what it takes” to force inflation higher.

The problem in a situation as we have now, says Krugman, is that central banks have too much credibility. Even if they say that they will create inflation, people don’t believe that they’ll let it get out of hand. It’s their job to control inflation, after all. So it’s hard for a central bank to boost inflation expectations.

In effect, to do so, “the central bank needs to credibly promise to be irresponsible”.

Now, I’m not sure that I entirely agree with any of these theories. Inflation expectations might matter at extremes. If you’re in Weimar Germany or Zimbabwe, then yes, you will spend your wheelbarrow full of money as soon as you get it, because by the time you’ve raced to the shops you know that you’ll need two wheelbarrows, and when you get to the checkout, you’ll need four.

But on a day-to-day basis in a semi-normal economy, the average person buys what they need based on: do I want it? Do I need it? Can I afford it? If I take on this debt, will I be able to pay it in the future? Can I depend on my job continuing to pay me enough to service this debt?

There are probably some psychological tipping points too – in the UK, when newspaper headlines start talking about the CPI hitting 5% or so, you start to feel a frisson of panic among the wider readership.

But my point is, you need to see some big moves before this stuff starts to filter down. And inspiring a general sense of personal financial wellbeing and security is far more important if you want to encourage consumers (or businesses) to invest and spend.

However, I’m not in charge of these things. And the point is, perhaps Krugman is right.

Janet Yellen, chair of the US Federal Reserve, has explicitly said that she’s willing to let the economy run hot for a while. Through both her words and deeds, she has “credibly promised to be irresponsible”.

And now big investors are starting to believe her. As one bond fund manager tells Bloomberg: “Central banks, after a long period of disinflation, are going to tolerate higher inflation. That is not good news for long-dated bonds.”

The big question now is: if inflation does pick up, how do central banks manage the inevitable impact on holders of this debt? I’ll be talking about this more later this week. Meanwhile, if you’re not already a subscriber to MoneyWeek magazine, I think now would be a good time to become one.