As inflation rises, central banks have their eyes on economic growth, not prices: Here's what's causing the bond sell-off

 
Will Railton
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Chinese Workers Make Shoes At A Factory In Wenzhou
Having fallen for the last five years, manufacturing prices in China rose in September, making imported goods more expensive for developed economies (Source: Getty)

Inflation is back, it would seem. After years of deflation and disinflation, recent data shows that price levels have been rising in the US, the UK and in the Eurozone.

After a peak in bond prices in July, holders of debt are now concerned that the yield on long-dated securities could be eroded over the coming years, or eaten up entirely if prices keep rising.

Last week saw a sell-off across global bond markets, with managers rushing to increase their cash positions. So what is driving this turn-around, and how can investors protect themselves?

What's behind rising prices?

The US is currently enjoying growth of more than 2 per cent, high levels of employment, rising wages and increasing healthcare costs, which make up a large percentage of the PCE index – the measure which the Fed uses to determine the interest rate. Indeed, markets expect the Fed to raise rates in December, and again next year.

But inflation is no longer the concern it once was for central banks. “Since the financial crisis, they have been focused on lowering unemployment, securing real economic growth and are perhaps willing to accept higher inflation rates,” says Anthony Doyle, fixed interest investment director at M&G. “Given the large amounts of debt that have built up on the public and private side, inflation is going to help lower debt burdens on governments, corporations and consumers.”

Read more: Thank competition – not magic central bankers – for years of low inflation

Deflation still remains a real threat to many rich world economies. Far from prices rising as a function of the economy heating up, rising energy and food prices are responsible to a large extent. From lows of $30 per barrel earlier this year, the oil price has rebounded and is currently hovering at around the $50 per barrel mark.

And it may even rise further next year if Opec’s freeze in production materialises. Many central banks exclude fuel prices from their “core” inflation measure, but they tend to drive up prices in other sectors of the economy as it becomes more expensive to transport goods.

There is a clear asymmetry today in the fixed income market

“Just as shale has revolutionised energy in recent years, innovation in agriculture with seeds and fertiliser has caused food prices to fall, and by 25 per cent last year. Those are now rising again,” points out Marie Owens Thomsen, chief economist at CA Indosuez Wealth Management.

Once energy, food, alcohol and tobacco prices have been stripped out, Eurozone inflation was just 0.7 per cent year-on-year in October, hardly enough to alter Mario Draghi’s course on asset purchases.

Currency weakness is another factor in inflation. As a consequence of the falling pound pushing up import costs, UK economists expect inflation to reach as high as 4 per cent over the next two years. But few think the Bank of England will respond to this pressure by raising rates with the impact of Brexit on the economy still uncertain.

Read more: Spooky sterling: Pound spikes against the dollar

“Price stability remains the cornerstone of central banks’ monetary policy framework,” says Jean Medecin, member of Carmignac’s investment committee. “But priorities have been inverted in comparison to the last 35 years, when the focus was on preventing the rise of inflation. Today, central banks are equally worried by price developments which are too weak.”

Bad for bonds

The problem is that the threat of inflation is only starting to dawn. “Investors have remained extremely complacent over the summer,” says Medecin. “There is a clear asymmetry today in the fixed income market.”

The easy bond profits are behind us

The low inflation and low growth of recent years have benefitted bondholders, because such securities offer investors income at a fixed percentage of the principal, which is returned to them when the bond reaches maturity. But in an environment where prices are rising, bond yields – particularly those with long durations – may be eroded entirely, with the real value of the principal diminished when it is returned. Medecin points to inflation-linked securities as a useful defence, because their yield rises with prices.

“A difficult environment doesn’t necessarily mean that there aren’t any opportunities,” says Owens Thomsen. “But it is hard to buy whole indices and markets. The easy bond profits are behind us.”

Cyclical equities, such as commodities, tend to benefit when inflation is on the up, and the companies behind common stocks are able to justify increases to their prices. Bank stocks are also in a position to profit from wider margins in economies like the US where interest rates will rise.

But the situation may be different if inflation rises suddenly, in an economy where there is a high level of uncertainty.

Read more: What deficit? Here's how to invest for a post-Brexit fiscal stimulus

Importing inflation

But if bondholders have been slow off the mark this time, another concerning source of inflation may just be making itself apparent.

Having fallen for the last five years, manufacturing prices in China rose in September, with the producer price index turning positive. This means that the countries which import from China, namely those with developed economies such as the US, Japan, Germany, Australia and the UK may be about to pay more for the goods they import.

Steen Jakobsen, chief economist at Saxo Bank, finds this concerning. “China has kept the disposable income relatively high for consumers in the US, Europe and Asia because their products have been sold with smaller and smaller prices,” he says. “China has been the main driver of deflation.”

Until now, it has suited China to keep exports competitive by keeping its currency low, just as it suits rich world central banks to inflate away their country’s debts. The impact this will have on investors is not yet clear.

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