The world’s bond markets are in turmoil. Investors now expect inflation to run hot for many years to come. Perhaps even decades.
The higher inflation rates have given most central bankers second thoughts too. Rate cuts are looking ever less likely.
It’s an extraordinary sea change from before 2021. Back then, some government bond yields were negative. Austria issued a 100-year bond with a coupon of 0.85%! Inflation seemed impossible.
In fact, central bankers and governments had spent years trying to engineer some inflation. In Japan, they’d been trying for decades. But inflation remained stubbornly low.
There were plenty of possible explanations for this. Demographics, for example. An ageing population borrows and spends less money.
But then 2021 came along and changed everything. At least, that’s the narrative causing chaos in bond and now stock markets.
Bull and bear markets go on for longer
than you thought possible
Back in the 70s and 80s, inflation seemed like an impossible problem to solve. Bond yields were double digits. Mortgages even more expensive. Prices were soaring every day.
But somehow we got a lid on things. And inflation began a 40-year decline.
Bond yields steadily fell with it, pushing up bond prices. The 40-year bull market in bonds became one of the immutable laws of investing. Betting against it was known as the Widowmaker trade.
Each time bond yields went lower, it seemed they couldn’t fall any further. The trend got a bit absurd. I mean who would be willing to put up with a 2% bond yield when central bank inflation targets are around 2%? It’s agreeing to a loss, in real terms.
But lower and lower bond yields went. Even a European sovereign debt crisis couldn’t halt the decline. Until bond yields hit 0%. Actually, until they went outright negative. And just kept going during the start of the pandemic.
Yields got so absurd that the Danes had negative interest rate mortgages.
Secular change?
Although financial history gets a bit messy going back so far, very long term bull and bear markets in bonds are the norm. Interest rates spend decades rising and then decades falling. We call them secular trends.
The big question we faced since 1980 is when the bear market in bond yields would end and a proper secular bull market would begin. And 2021 seems to have cracked that nut.
Seems to. But I’m no longer so sure the secular bull market in interest rates and inflation really has begun.
This is a bit of a shock to my own system.
In 2020 I argued that governments and central banks would spend the next two decades colluding to generate high inflation. That’s because inflation makes the national debt accumulated under COVID easier to repay.
In April 2021 I warned readers that the inflationary spike was about to begin. Weeks later, it took off.
So it appears my predictions about inflation have come true.
But it’s the why that has me worried.
It could be just a headfake
As a teenager, I played a lot of basketball. A US marines drill sergeant stationed in Germany was my first coach. And no, he wasn’t retired from the military at the time…
When we moved to Australia, I encountered a very different sort of game. With the bullies off playing rugby league and Aussie rules, basketball was left for the more…image conscious sort of teenage boy.
One of them – the local league coordinator’s son – was such an excellent player that he had to join the age group above his own.
But he had one bizarre weakness. A habit of making enormously large headfakes. He’d dribble along towards a defender and then throw his head out to one side in a manner befitting a Shakespearean actor in the age before Opera glasses were invented. He’d stick his tongue out and all.
The idea was to fool the defender into thinking he’d try to pass on the side his head was moving in the direction of.
Invariably, he’d pull his head in and go the other way. Making him predictable.
My worry is that the 2021 inflation spike is a ginormous headfake. It has convinced investors that the age of falling inflation and bond yields is over. When it is not.
And it’s the reason why inflation spiked in 2021 that has me so worried. You see, it wasn’t the sort of reason that you’d expect to repeat or sustain itself.
The velocity of money recovered,
but didn’t rise
My 2020 prediction of rising inflation was about government policy. A deliberate attempt to default on national debts by printing money. This would take time and take inflation above say 5% per year for many years.
My 2021 prediction that inflation was about to burst higher was based on a different argument. A short-term factor called the velocity of money.
It’s quite simple, really. Imagine if the money in our economy were suddenly spent 20% faster. It would feel like the money supply had increased by 20%. And cause 20% inflation.
And that’s what happened in the US between 2021 and 2024. The velocity of money rose by about the same amount as inflation took off. In other words, it was the velocity of money, not supply chains or QE, that caused our inflation in 2021.
The reason why is also simple. During the pandemic lockdowns, we couldn’t spend money. And so the velocity of money plunged. Central banks flooded the world’s economies with money to try and offset this – huge QE.
But once the lockdowns ended and revenge spending took off, the velocity of money surged back to where it was before lockdowns. And it had a huge increase in the quantity of money to send gushing around the economy. After all, central banks didn’t drain the money supply to offset the recovery in the velocity of money.
Again, this bounce back was the source of our inflation. Not supply chains, government spending or QE. It was the sudden surge in the speed with which money circulates in the economy.
That scenario won’t repeat
We aren’t going into or out of any lockdowns anytime soon. And so there is no obvious prospect for the velocity of money to surge again as it did in 2021 and 2022.
Instead, I would expect the pre-2021 forces to make themselves felt once again. A declining velocity of money on the back of demographics and other factors.
Now, I’m not entirely convinced of my own theory here. Governments and central banks will certainly try to engineer more inflation for a decade or two to come. But I’m not so sure they will succeed.
If they couldn’t engineer inflation before 2021, and 2021 was caused by a once-off factor, where will the inflation come from in 2025?
Declining inflation would rewrite
financial markets
The implications of this argument are enormous…if it’s correct. Bonds are pricing in sustainably high inflation for many years right now. If it fails to show up and inflation falls instead, that could cause another radical repricing in the bond and then stock market. Both prices could soar. And interest rates could get cut rapidly.
But it also recreates the risk of sovereign debt problems in Europe and Japan. It’s tough to run an overindebted government if you have neither GDP growth nor inflation. And immigration to cover up the problem is growing increasingly unpopular.
I hope this analysis has given you pause for thought on expecting inflation to persist. Unless you have a particular reason for its continuation, such as crazy energy policy or a fiscal crisis.
Predictions of inflation surging have been wrong so many times in the last few decades, and only correct once. Don’t fall for the headfake.
Regards,
 |
Nick Hubble,
Editor, Strategic Intelligence Australia
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