22 December, 2021

On Bonds and Inflation

Letter from Corrado Tiralongo

Developed market government bonds have rallied across the board since the news about the Omicron variant emerged. Corporate credit spreads have risen and are now at their highest levels in months. In the grand scheme of things, they are still very low in most cases. That makes it hard to see corporate bonds performing a lot better than government bonds, even if the global economy proves resilient to the new strain of Covid.

Inflation is set to stay higher for longer than we previously envisaged due to goods shortages, which are worsening and will persist for some time given lean inventories, pandemic-related shutdowns in Asia, and strong demand for imported goods. These pressures should start to ease next year. But there is a risk that the shortages trigger a more persistent pick-up in price pressures, particularly when labour is also in short supply. Staff shortages are most pronounced in the U.S. and intensifying rapidly in the U.K. and Canada. While we expect inflation to ease back to below central bank targets in the next couple of years in Japan and Europe, it will settle at higher rates in the U.S.

“The simplistic view of the world is that bond portfolios automatically lose money if interest rates rise.”

What investors fail to see is that bond markets, just like equity markets, currently price investor expectations. The simplistic view of the world is that bond portfolios automatically lose money if interest rates rise. It does so only for parallel changes in yields resulting from an instantaneous shock in the yield curve. Experience tells us that changes in interest rates rarely occur instantaneously. Instead, they typically occur across a cycle that will last weeks, months, or even years. When interest rates rise over time, one must factor in the yield curve’s slope to estimate the likely impact on bond returns. For example, a steep yield curve is indicative of a bond market that is expecting a dramatic increase in interest rates in the future. Forward yields provide a “buffer” that compensates investors for these future increases in interest rates. This buffer means that not only are bond investors not guaranteed to lose money in a rising interest rate environment, but they can also actually earn positive returns as long as spot yields increase by less than what was priced by the forward yield curve.

“The ongoing fear of inflation is a bit overdone, in my view.”

The ongoing fear of inflation is a bit overdone, in my view. Yes, there is inflation, and it is higher than in the past for the reasons that I have discussed in my previous musings, and in my opinion, it doesn’t spell the death of bonds for the fixed income investor. However, there are four scenarios that I can envision. If you are a bond investor, I would carefully consider the following and apply your expectations for each scenario to help you determine how you should be positioned going forward and how aggressively. Remember that the bond market is currently pricing in certain expectations, and those expectations are priced into today’s bond market. If you subscribe a higher weight to any of the other three scenarios, it means that you are expecting a different outcome than the market and therefore you should position yourself accordingly.

Scenario #1 - Base Case: As expected, the Fed announced it would start tapering its asset purchases at its November meeting but reiterated that it views the surge in U.S. inflation mainly due to imbalances caused by the pandemic. The Bank of Canada called time on its Q.E. program in late October and indicated that it could raise interest rates as soon as the second quarter of next year. While the inflation outlook will dominate central banks’ decision-making, they will also have to consider at least two other things.

The first is that asset prices around the globe are now underpinned by the expectation that real interest rates will remain low. If that expectation shifts suddenly, it could trigger dramatic repricing across asset markets. This is true of financial assets such as bonds and equities and assets like housing. What’s more, while the economic backdrop matters, it may not take a big move in interest rates to trigger a fall in risky assets. A modest drop in asset prices won’t necessarily concern central banks. But a large or more disorderly fall in asset prices could lead to a tightening in financial conditions that at best would threaten the recovery and at worst might undermine financial stability. Either way, it’s not a risk that central banks can ignore.

“Total global debt has ballooned to 250% of world GDP in the wake of the pandemic.”

The second and related concern that central banks will need to keep in mind is that ultra-low (currently negative) real interest rates hold the key to debt sustainability. Total global debt has ballooned to 250% of world GDP in the wake of the pandemic. While there are differences across countries and sectors, a common theme is that the fiscal costs of the pandemic have pushed up public debt burdens across all major economies.

So, what are the current market expectations? The following handy website illustrates the current market expectations: Countdown to FOMC: CME FedWatch Tool (cmegroup.com). We see that the bond market is currently pricing in no increases in the Fed funds rate for December 2021 and January 2022, and a 25 – 50bps increase in June. Investors holding bonds are currently being compensated for those expectations.

A smooth path ahead depends on inflation dropping back next year, thus allowing central banks to withdraw support gradually and, to the extent interest rate policy is tightened, ensuring the scale of tightening is modest. On balance, this is still the most likely outcome. It may mean tolerating slightly elevated rates of inflation (say, 3% or so in the U.S.) but, under these conditions, the sky won’t fall in on the world economy.

“The much bigger headache comes if the current inflation shock is larger or more permanent than we currently anticipate.”

The much bigger headache comes if the current inflation shock is larger or more permanent than we currently anticipate. Economic costs start to mount when inflation averages around 5% for a sustained period. This would be the stuff of nightmares for central banks. On the one hand, it would necessitate a much larger monetary policy response. On the other, that policy response would cause much greater market dislocation that could undermine financial stability. Faced with this threat, central banks may reason that a small increase in rates now will avoid the need for more drastic action along the line.

Scenario #2 – Rates rise more and or higher than base case expectations. In this scenario, central banks have to raise rates higher and/or faster than the base case. This situation would be negative for bonds and potentially for all risky assets depending upon the degree. What might cause this to occur? Wage pressure due to a continued shortage of workers or higher than expected economic growth would cause central banks to raise rates to curb economic activity. However, as noted above, central banks are treading a fine line. Their incentives and the market expectations are for rates to remain ultra-low. Investors calling for significant inflation hedges expect that inflation will be significantly higher than current expectations. If this scenario were to come to fruition, their bond portfolio would be the least of their concerns. Markets would significantly and swiftly reprice all risky assets.

“In my opinion, this is the more likely scenario for a couple of reasons.”

Scenario #3 – Rates rise modestly, less, or lower than base case expectations. In this scenario, central banks raise rates less than current expectations, or those increases are further out in the future. In this scenario, bonds will do better than expected due to the “buffer” priced in the forward yield curve. In my opinion, this is the more likely scenario for a couple of reasons. The first is behavioural. Investors are typically too pessimistic or too optimistic in their expectations. This has been shown time and time again in the past as future rate increase expectations have been typically less than what has been priced in the forward yield curve. Of course, there are no guarantees.

The second reason is that the war against Covid is far from over. We are learning to live with it, but each new variant will continue to weigh on individual economic activity even if there are no further restrictions on movement. Remember that the majority of the causes of current inflation are frictional and caused by pandemic restrictions (remember that the goods that you see in your store were produced six to 12 months ago). Given that most developed economies are learning to live with Covid, the pipeline of goods is slowly catching up. November’s manufacturing Purchasing Managers Indexes suggest that global industrial production has continued to expand, albeit at a slower pace than earlier this year. There are tentative signs that supply disruptions may be easing. Lastly, the rebound in oil and gas prices means that energy has been responsible for around six-tenths of the rise in inflation this year. We believe that energy’s contribution to inflation should fall sharply in 2022, causing headline inflation in most economies to decline too. The Omicron variant may alter the inflation picture by accelerating the decline in energy prices. All of this will complicate the already-complex challenge facing policymakers. The threat of a new, more serious variant of the virus may cause central banks to postpone plans to raise interest rates until the picture becomes clearer.

Scenario #4 – Central Banks cut rates and resume Q.E. Programs. In this scenario, central banks cut rates aggressively and resume Q.E. to provide liquidity and support, just as they did during the meltdown of mid-February and late March of 2020. A new Covid variant that significantly reduces the effectiveness of current vaccines would put economic activity and financial markets in a tailspin, and we would have a repeat of March 2020. I don’t ascribe a high probability to this scenario, but it isn’t zero. As I mentioned before, we have a long way to go before declaring the Covid war won.

“…investors should think carefully when making significant changes to their fixed income strategy.”


I believe that scenarios 1 and 3 with (hopefully) a longshot possibility of 4 all represent shades of the most likely outcome. That leaves a much lower probability of scenario #2 coming to fruition, and even then, it is likely a muted version. Therefore, investors should think carefully when making significant changes to their fixed income strategy. Aggressively protecting against scenario #2 can cost an investor dearly if it doesn’t play out as expected. From our perspective, we aren’t positioned as if there was going to be a bond Armageddon at this time. We do have a meaningfully lower duration versus the bond market), have taken on measured credit exposure, and have meaningful foreign government bond exposure in specific emerging markets such as Indonesia, Brazil, and Chile. These countries have low to moderate debt loads and are well-positioned for accelerating global demand. Lastly, our equity positioning within our portfolios is already a good hedge against moderate inflation. There is still a long recovery ahead for the global economy, fraught with many twists and turns along the path. There are no certainties along this path. Prudence is required.