Bonds, Yields and Inflation: Why The Recent Bond Market Volatility Matters
IT takes something special to unsettle the behemoth that is the American financial system – after all, being the centrepiece of the world’s largest and most powerful economy (for now at least) has to count for something. So when Wall Street begins to feel the jitters over an economic phenomenon that hasn’t even happened yet, it’s definitely worth taking note.
Over the past few weeks, the price of American and Australian government bonds has fallen sharply. Noting that the price and yield of bonds share an inverse relationship, the fall in prices has propelled yields in the opposite direction, with the yield on the 10-year Australian government bond reaching double what it was just last November.
But why should we care?
The short answer is as simple as it is ominous: inflation.
This economic phenomenon of upward pressure on prices coupled with deteriorating consumer purchasing power is not something policymakers in developed economies have had to worry about recently. In fact, one could go as far as to argue that due to the effects of globalisation, technological development and low unionisation, central banks including our very own RBA have been desperately trying to increase inflationary pressures for much of the last decade. [i]
This trend looked set to continue following the onset of the COVID-19 pandemic last March and the subsequent doomsday predictions for economic growth which reverberated around the globe. While the end of awkward zoom meetings and cringeworthy elbow bumps will be welcomed with open arms, the arrival of inflation to the post-pandemic recovery certainly won’t be.
With inoculation programs well underway in much of the western world, and Joe Biden’s jaw-dropping US$1.4 trillion stimulus package passing a more fervently protected US Congress, markets are worried that a faster than expected recovery will place upward pressure on consumer prices – driving inflation.[ii] Not only is demand inflation set to explode, but the supply side remains under siege as global supply chains are yet to recover from the destruction of last year.
It is a similar story down under. Australian Treasurer Josh Frydenberg’s swathe of stimulus payments and economic support measures have left Australian households more cashed up than ever before, with the household savings rate reaching its highest level in 60 years.[iii] And with much of the country returning to – dare I say it – relative normality, inflation is a very potent threat.
So why is it that the mere threat of inflation is enough to send: bond prices tumbling like a US President boarding Air Force 1; yields soaring like Tex Walker against Geelong last Saturday; and the stock market into a state of pandemonium like a Royal Family after watching an Oprah interview?
Another short answer: interest rates.
Inflation-targeting reserve banks like the RBA use interest rates to regulate the economic cycle, and thus by extension, the pace of inflation. If the Consumer Price Index (Australia’s measure of inflation) were to rise, it places immense pressure on RBA Governor Phillip Lowe and his crew at Martin Place to raise the cash rate in response. It’s the expectation and fear of this exact scenario which has underpinned the fear in bond and equity markets over the last few weeks.
Rising bond yields not only signal that the market is pricing in future inflation, but also increases the risk-free rate of return used to valuate investments. In economies like the United States, Australia and Japan, government bonds are theoretically the safest bet for investors, and therefore the yields on these government bonds act as a comparison tool for stock market evaluations and investment decisions. A rising yield will erode the value of a company’s future cash flows, thus deflating their valuation and ultimately their stock price. This is especially dangerous for technology companies, whether they be listed on the ASX or the tech-heavy New York-based NASDAQ, as such companies (think of Buy Now Pay Later market darlings like Afterpay) often boast inflated valuations based on expected profits as opposed to current earnings. [iv]
For bondholders inflation expectations are even more disastrous. The prices of the bonds themselves plummet as we have seen in the current environment, and rising yields have a devastating eroding effect on their fixed-interest payments. [v] This all comes down to the time value of money; the higher the yield, the higher the market risk-free rate, the less value future cash flows hold for investors.
Unfortunately, the problems don’t end there. An increase in interest rates during the economic recovery is dynamite for an Australian household sector suffering from widespread mortgage stress and indebtedness, which risks sparking an avalanche of foreclosures [vi]. At an industry level it would be equally damaging for businesses who have taken advantage of record low rates over the last few years; and the resultant rise in the Australian dollar (which we are already starting to see) places our export-reliant industries at a disadvantage against international competition.
While the above definitely isn’t pleasant reading, Governor Lowe has been doing the rounds amidst the recent volatility, assuring the public that the current ‘lower bound’ target cash rate of 0.1 per cent is ‘very likely to remain at its current level until at least 2024’. [vii] Lowe sets out a number of macroeconomic goals which need to be achieved before the RBA even considers raising the cash rate: full employment, 2-3 per cent wages growth and persistent inflation within the RBA target range of 2-3 per cent growth in the CPI.
With wages growth currently sitting at a record low of 1.4 per cent and unemployment at 5.8 per cent as of February, Australians should feel comfortable that there will not be any unexpected rate hikes out of Martin Place for a while yet. This confidence is crucial, because unless consumers, businesses and equity markets can trust the Reserve Bank to stick to its word, expectations of inflation cause a panic that is a phenomenon in itself.
Governor Lowe has talked the talk. Now let’s hope he can walk the walk.
[i] Abc.net.au. 2021. ‘Some of the best times I’ve seen’: The COVID-19 economy had big winners — but it might not last. [online] Available at: <https://www.abc.net.au/news/2021-02-23/covid-australian-economy-winners-and-losers/13159044> [Accessed 19 March 2021].
[ii] Australian Financial Review. 2021. There’s no interest rate rise on the RBA’s horizon. [online] Available at: <https://www.afr.com/policy/economy/there-s-no-interest-rate-rise-on-the-rba-s-horizon-20210309-p5797h> [Accessed 20 March 2021].
[iii] Australian Financial Review. 2021. Worst bond blood-bath since 1994. [online] Available at: <https://www.afr.com/wealth/personal-finance/worst-bond-blood-bath-since-1994-20210225-p575nn> [Accessed 19 March 2021].
[iv] Ft.com. 2021. ‘Humbling’ week in bond markets leads to fears of paradigm shift. [online] Available at: <https://www.ft.com/content/1982faaf-4cff-4e56-9b81-ce4a3e8ebcf5> [Accessed 19 March 2021].
[v] Ft.com. 2021. Q&A: The bond market shock. [online] Available at: <https://www.ft.com/content/ff064e39-a153-4817-be6f-92d23614dfeb> [Accessed 20 March 2021].
[vi] NewsComAu. 2021. Aussie housing affordability worsens amid debt disaster fears. [online] Available at: <https://www.news.com.au/finance/real-estate/buying/australian-housing-affordability-worsens-amid-fears-proposed-safe-lending-laws-repeal-will-lead-to-debt-disaster/news-story/6acc551da0e1b8e1ace2d9fd980335d3> [Accessed 20 March 2021].
[vii] Tradingeconomics.com. 2021. Australia Inflation Rate | 1951-2020 Data | 2021-2023 Forecast | Calendar | Historical. [online] Available at: <https://tradingeconomics.com/australia/inflation-cpi> [Accessed 19 March 2021].