Traders Speculate Central Banks Willing to Tolerate Higher Inflation
Inflation, which remained subdued for many years in the developed world, is becoming a problem for some. This time, they aren’t central bankers, but bond traders who are speculating that inflation is coming back again.
And the first casualty of higher inflationary expectations will be the bond market, where yields have traded at record lows, helping companies and small consumers borrow at the lowest possible rates in the past decade.
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But Monday was a reminder to investors that this party may not continue forever.
U.K. government bonds led the global selloff in bonds, with gilt yields on the benchmark 10-year gilt, hitting 1.22%—above levels recorded on June 24, the day after Britain voted to leave the European Union—before settling down to 1.12%.
Yields on 10-year U.S. and German debt hit their highest levels since June on Monday, with Treasurys climbing to 1.814%, before trading back down to around 1.772%. Yields rose in Asia, with Japanese government bond yields reaching as high as negative 0.47%. (Source: “Government Bonds Pounded by Inflation Fears,” The Wall Street Journal, October 17, 2016.)
The fear of accelerating inflation is coming after indications from economic policymakers that they’re probably willing to tolerate a higher rate of inflation than their targets, to boost growth in the global economy, which is struggling to show growth.
Inflation isn’t good for bond investors as it cuts their returns, pushing investors to demand more yield in compensation.
The U.K., in particular, is facing a tough choice between maintaining low interest rates and keeping inflation in check after a sharp selloff in sterling. The selloff occurred when investors sold the country’s currency on fears that its exit from the European Union—Brexit—will hurt the economy. The pound has fallen around 19% against the dollar since June 23, and 16% against the euro. On Monday, the sterling was down 0.2% against the greenback.
In the U.S., the Federal Reserve has its hands tied as data from the world’s largest economy show a mixed picture. Job creation has been strong, but overall growth remains weak, with the key housing sector still recovering from a slump.
Traders in the bond markets are betting the Fed is unlikely to raise interest rates before the U.S. federal election in November, while many of them believe that a rate increase is possible, if the job market remains strong and there are signs of inflation picking up.
