In today’s issue:
- Governments need inflation to repay their debts
- But the inflation of 2021 wasn’t deliberate
- What if a 5.2% bond yield is exceptional value?
Back in 2020 I warned that inflation is the only way out of our Covid debts. I warned a decade of deliberately high inflation was about to begin. Governments and central banks would collude to send prices rising in the hope of devaluing national debt loads.
Those predictions came true in 2021. At least, they appeared to.
Inflation spiked. And central bankers initially ignored it, before claiming it was “transitory”. That’s because they wanted to let inflation run hot as part of their policy to deal with debt.
The ploy worked, with inflation cutting debt burdens radically in many places around the world. Unfortunately, it was only the beginning of the process. And so investors need to prepare for plenty more inflation to come.
That describes the narrative I’ve been telling myself and anyone who’s willing to listen. But there’s a flaw to this story, which has me worried.
What if the inflation of 2021 was triggered by a once-off shock and not deliberate government policy? What if engineering inflation is actually out of reach of governments and central banks?
What if inflation is about to moderate and fall dangerously low instead of rising higher as everyone now expects?
I think it’s a very real possibility that investors need to consider. It’s not my prediction of what’s most likely to happen. But I’m getting worried about the growing probability…
Today and tomorrow, we’ll examine this scenario and what it’d mean for investors. It’s not the simplest story. But it may be the defining issue of the next decade. And everyone seems to be presuming it’s impossible.
Inflation is now the base case scenario
At 3% government bond yields, 5% inflation has an immense power to devalue your national debt over time. This was the central bankers’ plan.
But that presumes bond yields will stay below the rate of inflation.
While inflation is a surprise for investors, or while it remains “transitory”, this is a plausible state of affairs.
Bonds don’t price in today’s inflation. They price in inflation over the full life of the bond. If investors expect inflation to come back down over the life of the bond, bonds can yield less than inflation today. Investors appear to be losing money with consumer prices rising faster than their bond returns. But they are betting this is only a temporary state of affairs.
What has happened over the past few months is an awakening about inflation long term. People now expect inflation to remain high, as a matter of government policy. And so bond yields are adjusting for this.
Bond yields are spiking all around the world, except China. Investors are not willing to lend to a government for 3% if they suspect the government is attempting to engineer inflation of 5% for years to come.
This undermines the “inflate away your debt” playbook. Bond yields are now extremely high – higher than inflation is likely to be. That’s where we are now.
It’s why the Treasury had to intervene in the bond market last week. And why bond yields are suddenly mainstream news again. Inflation is no longer going to save us from our Covid debts. The game is up.
Capital controls are coming
Historically speaking, when bond markets catch a whiff of the government’s plan to inflate away debt, bond yields jump as they have recently.
But this is a game of chess where one side can change the rules. The government can respond to its higher cost of borrowing in several ways.
One way is to use the law to corral investors into owning bonds. In other words, force us to accept getting ripped off by inflation over time.
For example, the government could mandate that banks, insurance companies and pension funds own lots of government bonds, creating a captive market for them.
Actually, they pretty much already do so under capital adequacy rules known as Basel II. It’s why so many banks and pension funds own so many government bonds, putting them at risk when government bond prices fall. UK pension funds learned this the hard way in 2022 and US banks in 2023.
By creating artificial forced demand for government bonds in this way, the government can keep a lid on bond yields and get back to inflating away the debt without worrying about who will buy the bonds at yields below inflation.
There’s a fly in this ointment for the UK though. Just as the UK’s inflation index-linked bonds undermined the inflate-away-your-debt strategy in 2021, so too would foreigners likely blow up the capital controls plan.
You see, foreigners own a lot of UK government debt – about a quarter of the debt outstanding. And they won’t stick around to discover how capital controls will affect them. They’ll sell out.
Without foreign demand to soak up UK debt issuance, yields could surge… are surging. The falling pound last week was the giveaway that this exodus of foreign investors is already occurring.
Until recently, the pound has held up remarkably against many currencies except the US dollar. I know because my income has been in pounds while my expenses were in yen and Australian dollars. I’ve had an enormous currency fuelled pay rise for years now.
But all that could reverse shockingly fast if investors in UK government debt get spooked.
So far so good
That explanation gets us up to date on what’s going on so far. It’s very much in line with my predictions from 2020.
Tomorrow I’d like to try and explain what has me questioning those past predictions.
In short, I’m not convinced that governments and central banks really can engineer inflation. And the 2021 inflation burst has tricked us into presuming they can and therefore will do so again.
Without inflation continuing to wreak havoc in coming years, the investment landscape would reverse drastically. The current rout in bonds would become a remarkable buying opportunity – 5.2% bond coupons could be excellent returns.
So, be sure to check out part two of my analysis tomorrow.
Until next time,
Nick Hubble
Editor, Fortune & Freedom
