I’ve been going on about inflation here for a while. Now markets are starting to bet on it as well. More importantly, they’re also increasingly convinced that central banks are going to be quite happy to let it "run hot" for a while. That would have major consequences for the average investor’s portfolio. That’s why you need to start thinking about it now.
Bond markets think that inflation is set to return. As Bloomberg reports, 30-year US Treasury yields have risen back above 2% for the first time in almost a year. And they’re not the only market - oil has headed sharply higher too.
We have to remember that this is all coming from a low base. Bond yields (in the US particularly) plumbed new depths after the coronavirus struck last year. At this point, we’re just returning to pre-pandemic levels. It’s a similar story for oil. The price has risen significantly, yes. But it’s only back to where it was last January.
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However, it’s clear that investors are not only firm believers in “reflation” – a post-Covid economic rebound – but also are starting to think about the return of inflation in the longer term.
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Financial repression is being priced in
This raises a tricky question: what will central banks do? Usually, rising inflation would spell rising interest rates. Rising interest rates means tighter monetary conditions. Even the most wilfully blind stock promoter would have to acknowledge that loose monetary conditions have had at least some role to play in the bull market of recent decades. So why don’t markets seem to be rattled yet?
This is where a different bit of the bond market comes in. As Brian Chappatta points out on Bloomberg, while market expectations for inflation have risen, short-term Treasury yields (interest rates) have not.
Put simply, inflation erodes the value of money. So the last thing you want to own during a bout of inflation is an asset like a US Treasury bond that pays a fixed income. If you do intend to hold it, you would normally demand a high interest rate (a high yield) to compensate for the fact that the value of this fixed payment is going to fall over time.
That’s not happening. Instead “real” yields on the short-term Treasuries (ie, what your return is worth once you subtract expected inflation from it) are at all-time lows. On the five-year Treasury, it’s almost negative 2%. In other words, if you lend money to the US government for five years right now, you’re technically locking in a 2% annual loss, assuming inflation meets expectations over that period (I say technically, because people buying at these levels are buying for lots of different reasons and none of it is with the primary goal of losing 2% a year in real terms).
Anyway, what does this indicate? It indicates that markets don’t expect interest rates to rise in the near future. In other words, investors believe the Federal Reserve when it says that it’s going to let inflation "run hot" over the coming years, to make up for previous periods of inflation being below target. Or to put it another way, financial markets are starting to price in financial repression.
Politicians are treating 2020 like it’s 2008, and that’s a mistake
There’s no mystery as to why markets are starting to believe in the inflation story. US president Joe Biden is planning to throw nearly $2trn at the US economy. The overall consensus is that this is probably more than enough – indeed, a lot more than enough, given that US household savings are already high.
But what matters most is the shift in political tone. The bias now is towards “do more” rather than “let’s be careful out there”. There’s a reason for that – we’ve spent 12 years running the printing presses at great speed to apparently no real effect.
That’s had two big effects: it’s created a sense of frustration at the slow pace of post-2008 recovery; and it’s created a false sense of confidence, that you can print as much money as you like (assuming you’re a big developed economy with its own currency) and there won’t be any consequences (or at least, if there are, you’ll be able to deal with them later).
This is where the risk to investors lies. You see, what we’re doing now is the classic thing of fighting the last war. Financial crises are not new – 2008 was one of the biggest, but it wasn’t the first. When a financial crisis hits, your banking system is crippled. That’s a problem, because the banks are how money gets into the wider economy. They are the transmission mechanism.
If that breaks down, then your economy is left without an engine. So you have to fix it. The big problem after 2008 is that the banks were not fixed quickly enough, or were fixed at different rates, or were fixed using the wrong solutions. It’s no coincidence that the US recovered first because it fixed its banks first. And it’s no coincidence that Europe took so long to recover because its banks are barely fixed now.
Throwing money at this situation (particularly in the way that the central banks did it), is like trying to light a fire with damp wood. Doesn’t matter how much kindling or firelighters you use. It’s not going to take.
Politicians have misdiagnosed the mistakes they made following 2008. They’re blaming “austerity” or a timidity in spending more. Instead, what they probably needed to do, more than anything else, was to be much more aggressive about nationalising, recapitalising, then re-privatising the banking sector (with all previous managements fired). But that’s easier said than done, the politics would have been nightmarish, and it was a very chaotic time.
Anyway, so 2008 was a financial crisis and a nasty one at that; 2020, on the other hand, was an exogenous shock. We discussed this the other day, but, to recap quickly, Covid has knocked the economy onto its back. However – while this has been a nasty blow – nothing is fundamentally broken about the economy. Once people start moving around and spending and working again, it’ll go back to something approximating “business as usual” (with some added faster-than-expected digital transitioning).
If you throw money at this situation, then the danger is that it’s more like pouring petrol on a nicely built, dried-out log fire. It’s going to go up and it’s going to go up fast. And, before you know it, you’ll be running around wondering where you put the fire extinguisher and stamping out embers on the carpet.
That makes this sound like a bad thing; I’m not sure it is. We’ve had a millstone of debt hanging around the neck of the global economy for a long time now. The easiest way to deal with it – now that we’re at this stage – is a flare up of inflation to burn the stuff off. A debt jubilee by the back door.
But it does promise to be chaotic. And it does promise to be bad news for certain types of assets, which is why you may need to think about your asset allocation more carefully than you have for a while. To understand all of this more, you should listen to our pre-Christmas podcast with Russell Napier. It’ll help you to wrap your head around the coming changes.
Anyway, we’ll have a lot more on this in MoneyWeek over the coming months. Subscribe now to get your first six issues free.
