I want to share a basic story why inflation can be a challenge. I want to make it simple and practical to understand as we are now hearing about inflation everywhere.
In the table above you can see the bond yields for major economic countries at different durations. For example the 5yr bond yields are negative in Germany, France and Japan as highlighted in red. We will save negative yields for another discussion. However it is suggestive of deflation and here we are talking inflation everywhere whats going on.
Enough talk lets get to the challenging point.
Think about it if you buy a 10yr bond for say $1 million in the US you will receive 1.56% interest per year for 10yrs and then receive your principal (1million) back. The problem is that when the economy has underlying inflation above the rate of interest you are earning then you are in fact losing money in real terms.
There are 100’s of charts I can share which show actual and expected inflation in the system. I am just going to share two. Headline CPI for the Eurozone is at 4% and as you can see in the chart below, people are piling into inflation hedged bonds, these are bonds that adjust their rates according to inflation expectations.
Think about it if you are a bond buyer. Would you buy a bond at a yield lower than the inflation rate. The obvious answer is no unless you thought inflation was going to come down during the course of the bonds lifespan. So what has to happen is bond yields need to rise to compensate the bond buyer/holder for tying up their money for the duration of the bond. As you can guess rising rates is not good for the economy. It means mortgage holders have to pay more of their household income towards servicing their mortgages. It means businesses who have borrowed money need to divide more of their revenue towards servicing debt. It means governments need to spend more of their budgeted revenues towards debt servicing. Inflation leads to higher interests which in turn leads to slower economic growth – capish..
I have been writing in my daily about the battle between the Australian RBA and the bond market. About 3yrs ago the RBA announced a strategy of yield curve control. They set the April 2024 bond yield at 0.1% and would simply buy bonds to drive the yield down to the said rate. However over the last few weeks the markets became concerned about interest rates and the rate of the May 2024 bond started trading above the 0.1% level up to 0.2%. The market and the RBA were having a battle with the Reserve Bank of Australia governor Dr Philip Lowe hanging onto his target. Friday a week ago he intervened in the market driving the yield close to 0.1% as he hung onto his belief that inflation was not yet a problem. Then this week the 0.1% was under pressure and guess what on Friday the RBA did not intervene and the yield shot above 0.7% so you can read from this that even the bigwigs believe inflation is a problem. I believe we will hear on Tuesday that the RBA has abandoned its yield curve control strategy of the last 3years.