What rising interest rates and inflation will do to markets

As governments continue to stimulate their economies, investors are betting on a “V-shaped’ recovery and the return of inflation. John Stepek looks at how that’s affecting markets, from bond yields to the gold price.

US president Joe Biden wants to spend a lot of money to stimulate an economy that some argue has already had plenty of stimulus. I’m not interested in discussing the “ifs” or “buts” on that one today. But I am interested in the effect it’s having on the market.

US bond yields have surged higher (and thus prices fallen) this week as investors continue to bet on the “reflation trade” – the idea of a “V-shaped” recovery, basically. Indeed, this has been the worst start of a year for bond investors since 2013, according to Bloomberg.

It’ll be interesting to see if more records get broken as 2021 continues.

Germany is having to pay to borrow money again

The bond yield surge is not just limited to the US. Far from it – one of the most striking “reflation trade” statistics is that, as Bloomberg reports, “Germany had to pay to borrow money for the first time in nearly a year”. More specifically, when the German government auctioned some 30-year Bunds this week, it ended up having to offer a positive yield.

That’s right – the German government had to offer investors a whole 0.1% a year to encourage them to lend it money for 30 years. I’m not saying it’s a bargain (really, I’m not) – even at eurozone inflation levels it’s still losing money in real (after-inflation) terms. But it’s a better deal than you’ve been able to get since last summer. Should you have felt compelled to lend to the German government, you’d have had to pay them for the privilege.

It’s not the only one. Even Japanese government bonds – an infamous short-sellers’ graveyard, making GameStop look like a rank amateur – are straining at the leash that attaches them to the 0% level. The ten-year has clawed its way to a whopping 0.095% – its highest level since March.

Why is this happening? Quite simply, investors believe that economic growth is coming back. And they don’t have to look too far for proof of the matter. Most economies have seen GDP rebound rapidly in recent quarters. Yes, that’s because it fell hard during lockdowns, as the sceptics always enjoy pointing out, incredulous at the market’s apparent optimism.

But markets don’t care about that; they already priced that in. It’s in the past. Markets care about what’s happening now and what’s likely to happen tomorrow. As a result, bond yields – you might prefer just to think of them as interest rates in this context – get pushed higher.

Why? Because if the economy is growing – rather than in a deflationary slump – then you’ll be able to get a positive return on other assets. You’re also not going to be as prepared to pay a premium for security. In other words, you’re not going to accept low interest rates just because you know that your money will definitely be returned to you at the end of the period. You care about the return on your capital again, not just the return of your capital.

Given that situation, why would you buy bonds? Therefore, demand for bonds goes down, prices go down. And as prices go down, yields (interest rates) go up.

Bond prices also fall because investors start to expect inflation to rise. If prices are rising then a fixed income (rather than one that can potentially rise as prices do – like a dividend, say) becomes less valuable, because £10 today won’t buy you as much in a year’s time.

Improving growth and rising inflation adds up to one scenario: bonds, especially low-risk government bonds, are no longer as attractive. And what makes it a little more urgent at this point is that bonds are also more expensive (ie, yields are lower) than they’ve ever been.

So relatively small moves can make the difference between an investor still making a bit of money and actually ending up losing quite a lot of money.

What’s the problem with gold?

One question that MoneyWeek readers might be asking right now is this: if these are all reflation trades, then why is gold doing so badly? It’s dropped quite sharply this week. Isn’t gold meant to be the ultimate inflation hedge?

It’s a little bit more complicated than that. More specifically, gold is a play on falling real interest rates (that is, interest rates after inflation is accounted for). In other words, gold does well when inflation is going up more rapidly than interest rates. That’s not happening at the moment. At the moment, interest rates are going up faster than inflation expectations, so real interest rates are rising, even if they are still pretty negative. On top of that, it’s a “risk-on” market (or it has been). People want to own things that are going up. Exciting things. Gold is more of a “risk-off” asset.

But if this goes the way I expect (and I could be wrong, of course), then inflation will end up rising faster than bond yields, because the Fed will act to stop interest rates from rising too fast, simply by buying more bonds (or threatening to, as the Bank of Japan has done). That’s “yield curve control” and financial repression, and it’s the way you stop a government from going bankrupt even when it spends lots of money. If that happens, then real yields will fall again (because inflation will rise while interest rates will remain static or even fall), and gold will rise (if history is any guide). In short, I’d hang on to it.

The part of the market that is more vulnerable to this dynamic (I think) are the “jam tomorrow” stocks. Tesla is the most obvious, but the tech sector is full of them. These are companies that have benefited from very low interest rates and very low inflation or deflation.

Even if interest rates are kept low, investor patience with these stocks will fade because discount rates will still have to go up to account for inflation, meaning that the value of their future earnings will fall in the present. That means the companies simply won’t be worth as much. Gold doesn’t have this problem because it doesn’t generate any earnings and so can’t be valued on a discounted cashflow basis. (I explained all this here in more detail).

The stocks that should do better are the ones that are plays on “real” assets (miners and big oil and maybe even real-estate investment trusts (Reits), though that’s a trickier call in this environment) and the ones that benefit from higher interest rates (banks).

We’re already seeing some of this playing out. Banks have had a good week or so in the UK, which should continue with them gearing up to pay dividends again. And as for the mining sector, both Rio Tinto and BHP just announced record dividend payouts. I’m old enough to remember the days when the idea of a miner being an income stock was laughable.

Anyway – this is what the reflation trade and inflation story is all about. In the longer run, inflation might get to the point where central banks feel the need to raise interest rates to contain it. By then, the real trouble will have started anyway (because they’ll only raise rates when it’s already out of hand).

But in the meantime – well, assuming Biden gets his package through Congress (and we might see Rishi Sunak turn his March Budget into more of a blowout than a cutback, if Boris Johnson has his way) – then it’ll be a case of “inflation or bust”.

Make sure you take it into account in your portfolio. We have some ideas on how to do that in the current issue of MoneyWeek magazine, out now. Get your first six issues free here if you don’t already subscribe.

Recommended

Inflation has returned – and it will get worse
Economy

Inflation has returned – and it will get worse

Signs of inflation are everywhere. And companies around the world are already raising prices as the price of raw materials climbs.
6 May 2021
Stockmarkets have a spring in their step
Stockmarkets

Stockmarkets have a spring in their step

Global stockmarkets have been basking in the post-Covid economic recovery as GDP, retail sales and manufacturing are all on the way back up.
23 Apr 2021
The inflation narrative has got overheated for now – but it’s inevitable
Inflation

The inflation narrative has got overheated for now – but it’s inevitable

With official CPI at just 0.4% in the UK, inflation seems to be everywhere you look except in government statistics. But it’s only a matter of time be…
24 Mar 2021
Here’s why inflation will take off after the pandemic
Inflation

Here’s why inflation will take off after the pandemic

There are lots of reasons to believe that we will see lasting post-pandemic inflation – increased demand and squeezed supply chains, for example. But …
22 Mar 2021

Most Popular

How will Joe Biden’s capital gains tax rise affect crypto prices?
Bitcoin & crypto

How will Joe Biden’s capital gains tax rise affect crypto prices?

The US president wants to increase capital gains tax – and that’s going to hit a lot of American cryptocurrency speculators. Saloni Sardana looks at h…
14 May 2021
Are we nearing the end of the negative bond yield era?
Government bonds

Are we nearing the end of the negative bond yield era?

As inflation gets going, the era of the negative bond yield – that investors have to pay governments for the privilege of lending them money – might b…
14 May 2021
Inheritance tax planning: the rules around gifting
Inheritance tax

Inheritance tax planning: the rules around gifting

There are plenty of legal ways to minimise an inheritance tax bill. Perhaps the simplest is to give away assets to reduce the size of your estate. Dav…
11 May 2021