A lot of people are worrying these days that an inflation fire is being lit that will be hard to put out as the economy gets stronger.
The spark for these concerns was a sharp sell-off in the bond market over the last month. Observers say falling bond prices indicate investors are worried COVID relief spending by governments will cause the economy to overheat, leading to higher inflation. Michael Burry, of “The Big Short” fame expressed his concerns very publicly on Twitter recently.
Economic growth is picking up again and the new U.S. administration is pushing an almost $2 trillion COVID relief package through Congress. The recent drop in bond prices has already sent interest rates higher than many observers expected for the full year. (Bond prices move inversely to the interest they pay, known as their yield.) The yield on the 10-year Government of Canada bond rose to 1.46% last week. That’s up from a 2020 low of 0.43%. Bond yields in the U.S. and other countries have also risen sharply.
Before looking at the inflation picture, let’s take a step back and recall the role bonds play in your investment portfolio. They are supposed to act as a shock absorber, offsetting volatility in the stock market.
Bonds served this purpose well in 2020. Their prices rose as demand for safe assets exploded during the first phase of the pandemic crisis. Their price appreciation compensated for some of the drop in the stock market and provided a safe cushion for people’s spending needs until equities recovered.
Now, as demand for safe assets abates, it’s normal for bond prices to fall (and interest rates to float higher). An uptick in inflation is also to be expected in the short term, during an economic recovery. The real question is whether it will get out of hand over the longer term as a result of the government and central bank stimulus being pumped into the economy.
While we don’t make predictions about the short run, I believe inflation is unlikely to run out of control in the coming years. Interest rates have been trending downward for the last 40 years, along with a long-term drop in the share of the population made up by young people.
Young people need to borrow money to buy homes, raise families, and start and grow businesses. By contrast, older people tend to have paid off their major assets and accumulated savings. They don’t need to borrow as much and, therefore, there is less demand for capital from an aging population.
It’s entirely possible, and quite likely, that both inflation and interest rates will continue to move upwards in the short term. With the re-opening economy, people will start to travel, go to restaurants, and attend events–spending some of the savings they’ve built up in their bank accounts.
But it’s likely to be only a short-term phenomenon. In the long run, secular trends, like the aging population, are much greater determinants of long-term movements in capital markets.
