Markets & Investment Outlook
In this section we look at a few topical areas of financial markets. In the first article we look at bond market volatility, which has seen steep falls in bond prices and losses for bondholders. We also look at whether gold is an effective hedge against inflation. Finally, we review the dangers of cryptocurrencies in the light of the current phase of ‘risk-off ’ in markets.
Bond market volatility
The recent turmoil in the bond markets is unsurprising although dramatic. The Federal Reserve Bank (the Fed), the US central bank, has removed the extra liquidity it was pumping into the bond market. In addition, the Fed has started tightening the benchmark Fed Funds interest rate 0.5% at a time and will continue to do so until inflation appears to be under control. In other government bond markets, inflation relative to bonds implies significant, albeit very late, tightening. For example, UK inflation in the second half of 2022 is expected to exceed 10% while UK interest rates languish at 1%, and in the Eurozone, inflation is circa 8% while the ECB interest rates are 0%.
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So why do we say the bond market turmoil is unsurprising? Inflation was thought to be beaten as a result of the world’s economic policies, notably monetarism. However, since the Covid outbreak and, to an extent, over the decade and a half since the financial crisis, monetary policy has been extremely loose. This is due to the printing
of money via Quantitative Easing, bond buying by central banks and ultra-low interest rates in the main markets of the developed world (US, Japan and the Eurozone). At times the interest rates in the Eurozone and Japan have been negative. If you print enough money and pump liquidity into the financial system, you will get inflation. Coupled with supply shocks coming out of China, high energy prices as a result of the Russo-Ukraine war and tight labour markets due to low birth rates, the result is explosive inflation. The yawning gap between key central bank lending rates, inflation and government bond yields can only result in one outcome – falling bond prices and rising bond yields (see table below).
Governments in the developed world have been working to get inflation back into the financial system to erode the future value of the bond payments they have to make. However, this is playing with fire in monetary terms because once inflation becomes entrenched in financial systems it can be very difficult to get shot of it.
