Allocations for inflation (part 3): when bond theories collide
In the third part of our series exploring the asset-allocation response to inflation, we look at the implications for fixed income.
Look in any macroeconomics textbook, and it will tell you that higher expected inflation will drive up bond yields. The reasoning is simple: inflation erodes the purchasing power of fixed cashflows, so investors seek compensation through higher yields.
However, look in any finance textbook and it will outline the “expectations theory” of interest rates. Long-dated yields should trade in line with expected policy rates over the maturity of the bond in question, plus or minus a risk premium.
These two theories are in harmony in a world hit by shocks that push inflation and unemployment in opposite directions. Economists call those aggregate demand shocks. There is no policy trade-off, economics and finance textbooks align, and higher bond yields are the likely result.
But the models come into tension in a world dominated by aggregate supply shocks. Events which restrict the economy’s capacity to produce goods and services (e.g. wars and pandemics) are likely to create higher unemployment and higher inflation. In conditions of extreme commodity scarcity, production needs to be shut down (so-called “demand destruction”). This leads to fewer jobs and higher prices. Policy is faced with a difficult trade-off as the two theories collide.
That is a good characterisation of the world we live in today. Central banks are grappling with whether to raise interest rates in response to an aggregate supply shock, often reaching different conclusions. The European Central Bank is soft-pedalling its response to the highest inflation rates in a generation. Emerging markets (led by the Czech National Bank) have taken a highly orthodox approach and tried to get ahead of the problem by raising rates aggressively last year. The Federal Reserve appears to have had a Damascene conversion to the cause of fighting inflation. The Bank of England lurches between warning about the need to act one week and the need for caution the next.
The point is that we haven’t seen a “one size fits all” policy response, and therefore shouldn’t expect a “one size fits all” bond market response. What does this mean for bond investors? I’d draw out five important conclusions:
- Unless you are in the business of explicitly hedging liabilities in a particular currency, we believe global diversification of nominal assets is just as important as global diversification of risk assets. If we accept that it is difficult to fully anticipate both inflation and the reaction functions of central banks, then global diversification of nominal assets is appropriate. It is hard to find a better advert for the benefits of that diversification than the differential in performance between the US Treasury market and the Chinese government bond market since the start of last year. The first has seen yields rise by around 120 basis points as US inflation spiralled to 8%. The second has seen rates fall steadily as Chinese inflation has dropped below 1%.
- Investing in bond markets (and currencies) with high inflation-adjusted yields to start with is likely to be rewarded over time. In this cycle, emerging-market economies have largely got ahead of the problem and started adjusting interest rates early in 2021. Let’s take Mexico as a typical example. In previous cycles, the Mexican central bank has shadowed the Federal Reserve. Today, it is well out in front, having raised interest rates six times in the past nine months. On average, real (i.e. inflation-adjusted) interest rates across emerging markets are around 500 basis points higher in emerging markets than in developed markets. Excluding Russia (recognising that’s a big caveat), emerging-market local debt has delivered positive returns for sterling investors this year despite an aggressive selloff in developed-market fixed-income assets.
- Central banks which are aggressive in response to supply shocks are likely to see their yield curves flatten and (eventually) invert. The term “bond vigilantes” was first used by Ed Yardeni in the early 1980s to describe the collective power of fixed-income investors to impose discipline on governments and central banks that refuse to treat inflation seriously. When central banks take a relaxed attitude to inflation, we should expect curves to steepen as the vigilantes refuse to finance their debt without higher risk compensation. However, when the authorities treat the problem seriously, the vigilantes don’t need to worry so much. That doesn’t mean that long-dated yields won’t rise. It just means that our playbook should be for the long end to rise by less than the front end. The response of the Czech bond market to aggressive monetary tightening in the past 12 months is the posterchild here. The US and UK markets are just following down that well trodden path.
- Bond investors need to get accustomed to higher volatility when the market is repricing the inflation outlook. For example, on the day of the Russian invasion of Ukraine, gilt yields dropped by the most in a single day since the early 1990s. That was despite a spike in inflation expectations and commodity prices. Why? In a word, “positioning”. The overwhelming consensus had been to be positioned for higher yields, and you tend to get large price swings when investors all lurch to one side of the market boat. High inflation doesn’t mean that bonds offer “return-free risk”, but it does mean that volatility will be higher than otherwise.
- And finally, we don’t believe in throwing out the bond baby with the inflation bathwater. Treasury yields have fallen during 17 out of the past 18 US recessions. Recession-inducing shocks are invariably negative for risk assets. Assets that typically do well in the face of a sudden downturn in growth are hard to find, and we shouldn’t lose sight of this important role played by the bond market.
- In the first blog in this series, Chris Teschmacher introduced the problem with inflation for multi-asset investors.
- In the second, John Roe analysed the key questions for managing inflation in a multi-asset portfolio.
- In the fourth, Willem Klijnstra looks at the role of currencies.
Unless otherwise stated, information is based on LGIM analysis as at 23 March 2022.