Bond Yields and Inflation Outlook

‍Chart of the Week

The chart shows the current status of various bonds. 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 are bonds with very high risk (government bonds of highly risky emerging markets with a default probability of 30–70%). The yield is shown in the respective local currency, while in emerging markets it is denominated in USD.

‍Why This Matters:

For a 10-year government bond in the United States, investors currently receive around 1.8% interest with almost no risk. That is significantly more than in Germany, where investors still have to pay for the government to take their money.

Last Wednesday, the latest increase in consumer prices — in other words, inflation — was published in the United States.

At over 7% inflation, the figure came in higher than expected. It is the highest inflation rate in the United States since 1980.

Inflation means a 7% loss in value on all cash holdings. In other words, money has depreciated by 7% compared to the previous year. To prevent this, you need 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 significantly negative. The only way for a U.S. bond investor to preserve the value of their wealth would be to invest in government bonds from emerging markets such as Turkey, Russia, or Argentina — with default rates of up to 70%.

This leads to almost all investment capital flowing into the stock market. Only there can investors still achieve returns that exceed the loss in value caused by inflation.

Side Note: Bond Prices

Over the last 30 years, interest rates have declined almost continuously. As a result, a bond investor could be confident that, during the bond’s term, they would be able to sell at a profit.

Example: You buy a bond issued by Nestlé at a price of 100, with an interest rate of 2% and a maturity of 10 years. After one year, interest rates fall from 2% to 1%.

Because the bond’s interest rate is fixed, the adjustment happens through the price. An investor purchasing the bond one year later should receive a 1% return — the same as buying a newly issued bond at the current interest rate. As a result, the bond price rises to 109 (reflecting the 1% yield over the remaining 9 years). The price then gradually declines back to 100 by the time the bond matures. However, an investor who needs cash can sell the bond at any time before maturity and, in addition to the interest earned, realize an extra capital gain.

In the United States, three central bank interest rate hikes are expected in 2022. The previously favorable situation for bond investors is now changing completely.

Using the same example as above, but this time the bond is purchased with a 1% interest rate, and rates rise to 2% after one year. The bond price then falls to 91 (reflecting the 1% difference over the remaining 9 years). The price gradually rises back to 100 by maturity in 9 years. An investor who needs cash before maturity may therefore face a loss of up to 9% — even with traditionally safe investments such as bonds.

Bond investors are facing difficult years ahead. Real returns (yield minus inflation) are expected to remain negative, alongside the risk of potential capital losses.

Inflation Outlook

For 2022, inflation represents the biggest investment risk. Central banks emphasize at every opportunity that inflation is only temporarily elevated due to COVID and will soon ease. They base their outlook on arguments such as this:

The chart shows the price index of purchasing managers at large companies in the United States. Over the past 20 years, this index has been a reliable leading indicator of inflation. The chart suggests that inflation is currently too high and should decline again in the coming months. Cost pressures on companies are easing.

However, whether this will actually happen remains uncertain.

The Federal Reserve Bank of New York has developed its own index that combines the various components of supply chain disruptions. The index does not yet show any signs of easing. Supply chains remain significantly disrupted and could continue to drive higher prices.

The chart shows unemployment (purple) and job openings in millions in the United States. The number of open jobs is higher than the number of unemployed people. In addition, there are partial skill mismatches among job seekers.

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

Disclaimer:

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