Bond yield and inflation outlook

Chart of the week

The chart shows the current status of various bond issues. On the far left are bonds with the lowest risk (government bonds of developed countries with a default probability of 0.1-0.3%) and on the far right, bonds with very high risk (government bonds of very risky emerging markets with a default probability of 30-70%). In each case, the interest rate is given in the local currency, in the emerging markets in USD.

Why this matters:

For a 10-year government bond in the USA you currently get about 1.8% interest with almost no risk. That is a lot more than in Germany, where the investor still has to pay that the government takes the money.

Last Wednesday, the current increase in consumer prices, i.e. inflation, was published in the USA.

With over 7% inflation, the value was higher than expected. It is the highest inflation in the US since 1980.

Inflation means a 7% loss in value on all the cash you hold. Money has devalued by 7% compared to the previous year. To prevent this, you have to invest your money.

If you invest your money in 10-year government bonds, the loss in value is reduced to 5.2%. That is less than 7% but still strongly negative. The only way for a U.S. bond investor to preserve the value of his assets would be to invest in government bonds in emerging markets such as Turkey, Russia or Argentina with default rates as high as 70%.

This leads to almost all investment money flowing into the stock market. Only there, one can still achieve a return that is higher than the loss in value due to inflation.

Excursus: Bond prices

Over the last 30 years, interest rates have fallen almost continuously. A bond investor could therefore be sure to sell at a profit during the life of the bonds.

Example: One buys a bond of the company Nestle at the price of 100, with an interest of 2% and a term of 10 years. After one year, the interest rate decreases from 2% to 1%.

Since the interest rate of the bond is fixed, the adjustment runs through the price. An investor who buys the bond in one year should receive 1% interest, the same as if one buys a new bond at the current interest rate. The price of the bond now increases to 109 (1% interest for 9 years). The price then decreases again to 100 until the bond expires. However, an investor who needs money can sell at any time before expiration and make an additional capital gain in addition to the interest.

In the USA, three interest rate hikes by central banks are expected in 2022. The previous pleasant situation for bond investors now changes completely.

Same example as above but the bond is bought at 1% interest and the interest rises to 2% in one year. The price of the bond now drops to 91 (1% for 9 years). The price then slowly rises again to 100 until maturity in 9 years. An investor who needs money must therefore reckon with a loss of up to 9%, and this with safe investments such as bonds.

Bond investors will face hard times in the coming years. Still negative real returns (yield minus inflation) and potential capital losses.

Inflation outlook

For 2022, the biggest investment risk is inflation. Central banks stress at every opportunity that inflation is only temporarily high because of Covid and will soon slow down. They base their outlook on arguments like this:

The chart shows the price index of purchasing managers of large companies in the US. This index has been a good leading indicator of inflation over the last 20 years. The chart suggests that inflation is too high now and should fall again in the coming months. Corporate cost pressures are easing.

However, it is not clear whether this will happen.

The Federal Reserve of New York has calculated its own index, which summarizes the various components of the supply problems. The index does not yet indicate any relief. The supply chains are still strongly out of kilter and could provide for higher prices.

The chart shows unemployment (purple) and job openings in millions in the US. The number of open jobs is higher than the number of unemployed people. On top of that, some of the job seekers lack skills.

It is quite possible that while the supply chain problems will diminish in the coming months, the pressure of wage inflation will increase. It is still too early to sound the all-clear.