Chasing the Inflation Dragon
After spending last year fretting about the damage to economic growth from the global financial crisis, many investors are now worrying that policymakers’ medicine may prove too effective.
The fear is that the stimulus injected by central banks, via interest rate cuts, and by governments, via additional spending and tax reductions, will create an intractable inflationary spiral that will force interest rates sharply higher and erode the value of fixed income assets.
The inflation warnings from some quarters have been sufficient to make those investors who last year fled equities and property in the rush for the perceived safe haven of fixed income feel like moving targets.
Inflation, commonly defined as a sustained rise in overall price levels in the economy, is bad for bonds in two ways. Firstly, it reduces the purchasing power of the fixed coupon payments upon which investors rely. Secondly it undercuts the inflation-adjusted capital value of the bond.
Inflation is less of an issue for the rival asset class of equities, at least in the short run, because companies to some extent can respond to higher input prices by passing these onto consumers, thus preserving their profits margins.
But as consumer prices start to ratchet higher, central banks respond by raising interest rates. This slows the economy by reducing demand and giving companies less pricing power. The subsequent environment of slowing growth and moderating inflation is generally seen as beneficial to cash and safe haven government bonds.
So if stronger growth and rising inflation are the next big worries on the global horizon, are investors taking unnecessary risks by investing in bonds? Before answering this question, it is worth making a few observations.
Firstly, it is not clear that inflation is the big concern that some people say it is. Indeed, until quite recently, the bigger concern for policymakers was the prospect of deflation, or an economy-wide fall in prices.
While that may sound fine on the surface, it is actually a grim prospect. That is because in a deflationary spiral activity can come to a halt as people put off spending today what they can buy more cheaply tomorrow.
In this environment, the normal demand instrument that central banks use – cutting official interest rates – proves ineffective. So the big guns come out.
With interest rates approaching zero in the United States and the United Kingdom, central banks there recently followed Japan’s example of early this decade and began “quantitative” easing – essentially expanding the size of their balance sheets to increase the amount of money in circulation.
It is the combination of this radical policy action by central banks and the associated deficit spending of governments to fill the gap left by shrinking private demand that has inflation hawks worried.
Indeed, the revival in equity markets, commodity prices and commodity-linked currencies like the Australian and New Zealand dollars in recent months is evidence that these “reflationary” policies are having an effect.
The bond market, too, has reflected the more positive outlook. The yield curve, the trajectory drawn by mapping interest rates on bonds of similar credit quality at various maturities, has steepened in recent months.
Central banks, by keeping official interest rates at historically low levels, are anchoring the short end of the yield curve, while yields on long-dated maturities have risen on expectations of stronger growth and rising inflation.
As yet, though, there is little evidence that inflation is becoming a particular problem in the developed world. Consumer prices in the 30-nation Organisation for Economic Cooperation and Development rose by 0.1 per cent in the 12 months to May, the lowest level since records began in 1971.1
And against that fairly benign backdrop, central banks in the US, Australia and elsewhere have signalled they are in no rush to start reversing their accommodative policy settings.23
The second observation about the risk of higher inflation is that markets are forward looking. As noted above, yield curves have adjusted to accommodate this prospect. In other words, the risk is already in the price.
But what if individual investors are still alarmed at the prospect of inflation and its impact on their fixed income investments? Probably the worst response is to seek shelter in a term deposit that pays a fixed and very low rate of interest.
Assuming official interest rates are about to rise – and that is by no means clear – it makes little sense to lock in one’s assets at a fixed rate that will soon be overtaken by the effect of policy changes.
Better to stick with a flexible, variable maturity approach which takes advantage of the steepest part of the yield curve at any one time and which, over the long term, provides a risk-adjusted return premium over cash.
That’s what Dimensional’s fixed income strategies are designed to do. They add to portfolio diversification, provide strong liquidity and have successfully delivered a premium over cash management trusts and term deposits.
These strategies are not dependent on interest rate forecasts. Instead, they use today’s yield curve as the best estimate of the future. Not being tied to an index means they can vary maturities according to the shape of the curve.
When the curve is inverted – shorter-term interest rates are above longer-term rates – these strategies can stick toward the cash end of the spectrum and harvest the higher returns. When the yield curve becomes more normally shaped, as it has recently, the strategy can move out a little further.
In a world where inflation expectations are forever changing and where the market in any case does a pretty good job of reflecting those expectations, this flexible approach makes sense.
It offers the benefits of diversification that bonds provide, it diversifies across the asset class in terms of both maturity and credit quality – within prescribed limits – and it does not depend on inflation or interest rate forecasts.
The inflation dragon may or may not be on its way back – no-one knows for sure – but investing this way lessens the chances of being torched.
1‘OECD Annual Inflation Rate Hits Record Low’, Dow Jones Newswires, June 30, 2009
2‘Treasurys Jump as Bernanke Eases Inflation Fears’, The Associated Press, July 21, 2009
3‘Barring a Shock, Rates are on Hold’, The Australian Financial Review, July 22, 2009
Source: Jim Parker, Regional Director, DFA Australia Ltd
Tags: inflation