Hopes for the end of lockdown are rising – and bond yields are rising with them.
In the UK and the US vaccination programmes are going very well indeed. Infection rates have plummeted, the strain on hospitals is easing and people are yearning for even the smallest taste of freedom. I know I am, at least. What a long, strange year it’s been; how amazing will it feel to go out to a restaurant again?
Of course, as we all know, UK politicians have been exceptionally cautious about reopening plans. As they say, once bitten, twice shy. Our governments have been bitten twice by COVID-19 resurgence, so they are quadruple shy. Given the virulence of recent mutations, it makes sense too, even though it increases the short-term strains on businesses and people’s state of mind.
So with lockdown so close everybody can taste it, yet still too far off to truly grasp, we find ourselves pondering what will happen when the shackles are lifted from households and businesses. Most particularly, how will it affect inflation and how would that inflation affect the cost of borrowing (bond yields and interest rates)? Everyone is asking this question. And everyone has part of the answer: there will be an almighty burst of activity at first. For all the caution about fluid timelines stressed by the Government, people have rushed to lock in cottage holidays in the countryside or flights to Marbella. Getting a restaurant booking this side of next winter is tougher than securing a vaccine.
This flurry of demand, along with curtailed supply – some airlines have gone bust, more than a few restaurants have folded, and those that survive can offer fewer tickets and tables because of restrictions – would likely send prices higher. I’ve used a few examples here, but you can extrapolate this phenomenon across most other sectors of the economy as well. Meanwhile important prices, like oil, industrial metals and shipping costs, plummeted a year ago as the world shut itself down. That means that any recovery back to normal levels or even a bit higher will make the inflation rate look very spicy. We’re starting to see some of these fears coming through into bond markets, particularly in the US Treasury market. The benchmark 10-year US government bond yield (how much it costs America to borrow money for a 10-year term) has marched higher in 2021, from 0.80% at the start of the year to roughly 1.50% at time of writing.
A passing phase
We are a bit less worried than most about the chances that this initial jump in inflation will lead to a sustained increase in the inflation rate. And remember, inflation is only an issue if it persists at a level near 3% or higher. A short spike will be sort of like an elephant passing through a snake: an interesting curiosity for people to talk about but it will sort itself out before you know it.
So what makes us think any jump in inflation will be a passing phase? First up, there has been a truly monumental disruption to commerce and people’s lives. That has left many people unemployed (its extent is hidden by government support right now). Once the initial euphoria of freedom has flared, people will start to regroup – especially if furlough schemes are removed at the same time. Unemployed people are less likely to shop, which has a knock-on effect for GDP and therefore inflation. Also, a year of flexible working has likely created new habits. That could mean less spending on everything from car repairs and train tickets to sandwiches and after-work pints.
Meanwhile, long-term forces that have kept inflation tamped down all round the world for decades are unlikely to abate. Digitisation continues to reduce costs and improve service quality. The world is even more indebted now than before the pandemic, so more income must go towards repaying it rather than spending on fun or productive stuff. And, finally, the world is ageing. While a greater number of senior citizens could create prices pressures in some specific areas, like healthcare (see our earlier blog for why we think it could actually have the opposite effect), it also means higher tax rates/insurance premiums on workers to pay for it and lower demand overall across economies.
So while inflation will shoot higher in the coming months, try to keep perspective. There’s a good chance that it will fall off just as quickly to a muted level. People will still worry though.
David Coombs, Head of Multi-Asset Investments, Rathbones
David is a panellist at The Scotsman’s free Annual Investment Conference on Tuesday 30th March in association with Martin Currie and Rathbones. Register here.