Yesterday I left you pondering the inflation comeback in Europe. Since I put that article together, Germany’s inflation data added to the argument, and eurozone core inflation hit an all-time record. Today, we focus on what this means for the bond market – where governments and companies borrow money and where mortgage rates are heavily influenced too.
But first, I’m just going to say that last bit again. Eurozone core inflation hit an all-time record of 5.6%. This a year after the European Central Bank president Christine Lagarde said inflation would come down in 2022, two years after she said it wouldn’t go up much at all, and three years after she said there wouldn’t be any inflation to you to worry about.
If you were in charge of keeping inflation at 2% and had a track record like that, would you resign or wait to be fired?
But back to the real topic. What does inflation’s comeback mean for investments?
Well, financial markets globally already got a bit upset about the European data because it signals that central banks will have to hike interest rates higher for longer after all.
The markets had been expecting central bankers to fold on their tightening plans as inflation plunged and the economy along with it. But now, with inflation turning up, the hawks will have to walk the walk, not just talk the talk. And so we’ll find out how hawkish they really are as the chickens come home to roost.
I suspect those geese hoped their talking, known as “jawboning”, would be enough to bring inflation back down in and of itself. And it had been working, with markets predicting rates wouldn’t need to go as high as central bankers said they were willing to go.
But then the game of bluffing and counterbluffing was upended when the actual data hit and inflation rose instead of falling – the one thing nobody was ready for.
Now that central bankers will actually have to show their hand, we’ll find out how tight they’re willing to go.
But what does it all matter to you? So far, nothing has gone wrong. I’ve been warning that the economy can’t handle such high interest rates for ages, after all. So far, nobody has dropped dead.
Unless you count house prices in much of the world, the UK government bond market, the Liz Truss government itself, the UK pension system, the US stock market, and a few other victims…
But all those were just canaries. And we’re in an entirely different mine now.
The big fear of economists and investors had been that inflation could settle at an unacceptably high rate, rather than falling back down to the 2% target that most central bankers are supposed to meet.
The solution proposed to this scenario was of course to raise the inflation target. But that’s another story.
The idea that inflation would turn around and make for higher ground altogether is a theory I’ve only seen from one person – Peter Schiff. And let’s just say he has a reputation for calls like this.
The bigger question now is whether inflation is going to come back for another go at asset prices in 2023, this time focusing on Europe. By which I mean that higher inflation prints hammer stock, bond and property prices lower again, as they did in the US especially in 2022.
Why would you expect that to happen?
Well, look at it this way: inflation in Germany, for example, is running at about 8.7% and rising. The yield on 10-year German government bonds is about 2.75%. Yields on Pfandbriefs, a way to invest in German mortgages, have risen from 0% in 2021 to 3.4% recently.
The point is that investors and lenders are losing money, big time, adjusted for inflation. To be clear, people who buy German government bonds and mortgage investments are losing money at current inflation rates by an extraordinary margin.
This only makes sense if you expect inflation to fall fast and far, and then stay low for a long time. The hope is that you’ll recoup your early inflationary losses.
But the recent data has put that into question. Inflation isn’t just high, it’s rising.
Which puts investors in an interesting position. If they decide they don’t want to wait around to find out whether inflation will fall low enough to justify their bond investment, they will sell out. This will cause bond prices to fall, raising their yields and thereby interest rates. (It’s the same as a dividend stock – the lower the price, the higher the dividend yield.)
For now, inflation is rising. But let’s not work with that alarming reality. If inflation merely halves over the course of the next ten years, then bond yields and Pfandbrief mortgage rates will have to double to provide a reasonable return.
Can the German government afford to pay that much interest? Can German mortgage borrowers?
A doubling in the yield also means plunging bond and asset prices. Will investors stick around and wait for that risk?
It’s not just Germany, of course. With eurozone core inflation at a record 5.6%, French 10-hyear bonds are yielding 3.2%, Spain’s 3.7% and Italy 4.6%.
But here’s the interesting bit. Shorter duration government bond yields for those countries are only yielding slightly less.
What is the rational for holding a 1-year European government bond at 3% interest when inflation is running over 8% and rising? It’s madness. There isn’t enough time for inflation to fall in order to recoup your inflation losses.
Unless, like I say, you expect a financial crisis which causes inflation to plunge… within the next year.
In such a scenario, there would likely be such a scramble out of the stock market and into the safety of the bond market, that government bond prices would surge, rewarding those holding them.
The problem with this narrative is the timeframes. It’s getting mighty expensive to hold government bonds as inflation rumbles onwards and upwards with no financial crisis emerging. How many times do 1-year government bond punters want to lose 5% of their money in real terms in anticipation of a financial crisis?
The gap between bond yields and inflation can only persist for so long. And if inflation isn’t coming down, then bond yields are going up.
The ultimate irony is that, if this were to happen, it would likely trigger the very financial crisis that bond investors are anticipating and holding bonds for in the first place.
Everyone knows what happens when you yell “fire” in a crowded theatre. But what if it’s the emergency exit doors that are on fire? That’s the scenario European bond markets face. And those bonds fund governments.
Nick Hubble
Editor, Fortune & Freedom
