Government bond prices around the world fall after Jay Powell confirmed last week that the Federal Reserve was willing to tolerate higher inflation as it steers the economy in the aftermath of the coronavirus pandemic.
But many investors say talking about inflation is one thing, generating faster price increases is another. Unless the Fed can avoid the path taken by the Bank of Japan and the European Central Bank – where sweeping monetary stimulus has failed to bring inflation back to target levels – a sustained reversal in the rise in four decades of fixed income is unlikely, they say.
“It’s very good that they say that, but they’ve been trying to get inflation above 2% since the global financial crisis, and that hasn’t been consistently possible despite strong economic growth, low unemployment and massive stimulus,” said Jim Leaviss, CIO of public fixed income at M&G Investments. “There’s a lot of skepticism about their ability to handle it now.”
Inflation is kryptonite for bonds, especially longer-term ones, because over time it erodes the real value of the fixed interest payments they provide. Analysts were quick to point to Mr. Powell’s embrace of faster price increases as the reason for a fall in bond prices.
The 10-year US Treasury yield hit its highest level in nearly three months, at 0.76%, following the Fed’s policy shift last week, reflecting lower prices before pulling back slightly. The 30-year yield soared to more than 1.5% at one point, from around 1.2% at the start of August.
However, on closer inspection, the moves were not primarily driven by inflationary concerns. Inflation-linked US government bonds also fell. The 10-year equilibrium rate – which tracks the spread between nominal and real yields and serves as a proxy for investors’ inflation expectations – hovered around 1.77%.
The relatively muted reaction is in part because the Fed’s pivot was widely expected – investors had been anticipating higher inflation expectations for months as the economy rebounded and Fed policymakers hinted that they would not rush to withdraw stimulus. But by setting prices in a decade of sub-target consumer price increases, investors are also expressing doubts about the central bank’s ability to meet its new average inflation target.
Inflation in the United States has increased only briefly over the past decade. Since the Fed officially adopted a 2% target in 2012, its preferred measure of inflation has topped that figure in just 16 out of 102 months, according to Rabobank strategists. Many fund managers are betting on more of the same.
“I think in some parts of the market there are concerns about inflation, [given the] combination of rapid monetary growth, a large balance sheet, rapid debt growth, some concerns about globalization shorting and beginning to reverse, and broken supply chains exerting upward pressure on prices,” said Nathan Sheets, chief economist at PGIM Fixed Income and former undersecretary for international affairs at the U.S. Treasury. “But the post-global financial crisis period has been a period of low inflation in the United States and around the world, and I expect the next period to be about the same.”
Investors are also informed by the experience of the Eurozone and particularly Japan, where the central bank has struggled with persistently low inflation for decades despite aggressive efforts to generate growth. The deflationary effects of demographic change, particularly acute in Japan’s rapidly aging society, are increasingly being felt globally, investors say.
Japan serves as a “Petri dish” for central bankers and their ability to generate inflation through monetary policy, said Nick Maroutsos, global head of bonds at Janus Henderson. “We should look at his model and say, ‘maybe we are not able to generate inflation’.”
Investors will likely need to be more convinced that a sustained acceleration in consumer prices is underway before bond selling can continue.
“At the end of the day, whether you think that’s good or bad for bonds ultimately comes down to your opinion of the power of monetary policy,” said Karen Ward, strategist at JP Morgan Asset Management. “Just because you say you want something doesn’t mean it’s going to happen.”