For much of the past 35 years interest rates have trended lower, taking bond yields with them. During what has been dubbed the great bond rally – a consequence of the fact that bond prices rise as yields fall – it has become increasingly difficult to find fixed-income assets with a decent yield for our portfolios.
But interest rates are now on the rise. Having hit a low of 0.5 per cent in 2016, the interest rate on a 10-year UK government bond has risen to 1.5 per cent. This has led to some speculation in the markets that the great bond price rally is set to reverse.
To assess the likelihood of such a reversal, it’s worth reflecting on the factors that have driven interest rates down over the past few decades. Short-term interest rates are set by the central banks: the Bank of England here in the UK and the US Federal Reserve in the US. But longer-term interest rates on government bonds depend on the balance between supply and demand, which in turn depends on whether investors have a preference for fixed income over riskier alternatives such as equities. The outlook for growth and inflation heavily influences this preference.
Fear of inflation has subsided
Over the past four decades, big changes in the global economy have led investors to worry much less about spikes in inflation than they did previously. With less risk that inflation would erode the value of fixed-income returns, the popularity of bonds soared.
These changes included deregulation and the breakdown of trade union power under the governments of Margaret Thatcher and Ronald Reagan in the 1980s. Workers couldn’t so easily work together to bargain for the higher wages that in turn led to higher costs and prices. Today the rise of the ‘gig’ economy has reduced the collective bargaining power of workers even further. These structural changes do not appear to be reversing.
Technology has also played a major role in minimising inflation. Price comparison websites and online retailers have made it easy for consumers to find the cheapest products, which has put companies under immense pricing pressure. One only has to look at recent results from the likes of Amazon and Alibaba to see that the impact of online retailing and internet technology on inflation is showing no signs of abating.
Another major milestone in the disinflationary process has been the entry of low-cost emerging markets into the global marketplace. When China joined the World Trade Organisation in 2001, the global workforce effectively doubled. Other populous, low-cost countries such as India, the Philippines and even Africa still provide ample opportunities for firms to outsource production to lower-cost nations.
In the developed world, households have benefited from the falling prices of televisions and other gadgets. But the benefits have not been universal, as certain blue-collar jobs have been lost to overseas competitors. This has polarised opinion about the merits of globalisation and affected the political landscape.
The recent actions of the current US administration to increase tariffs on a number of Chinese imports is a case in point. At the time of writing, it seems unlikely that this will spark a major trade war. However, markets are understandably nervous, given the role that free trade has played in driving down inflation.
There is another major structural change behind the great bond rally that we should not take for granted: the true and full operational independence of central banks. In the 1990s some governments gave major central banks such as the Bank of England detailed economic mandates to direct their economies in ways that avoid bouts of inflation. At this point, governments lost their previous ability to please the masses with low interest rates and engineered economic booms ahead of a general election.
Central banks have been focusing on fine-tuning monetary policy to meet their 2 per cent inflation targets, and they appear to have been successful in lowering and anchoring inflation expectations: firms and households are used to modest annual price and wage increases. Looking ahead, however, the independence of the world’s largest central banks faces an almighty challenge.
This is perhaps most apparent in the US. The current US administration has firm ambitions to ‘make America great again’ and has put in train a major fiscal stimulus encompassing significant tax reform. An infrastructure spending spree is next on president Donald Trump’s wish list, which at face value would push GDP growth this year and next towards 3 per cent.
This is the ‘right’ rate of growth according to many in the administration – a point emphasised by Senate Republican leader Mitch McConnell after the tax debate, when he said: ‘We’ve had two quarters in a row of 3 per cent growth. Coupled with this tax reform, America is ready to start performing as it should.’
But can the US economy sustain 3 per cent growth? The US has near full employment and the trend rate of growth in its workforce is roughly 0.5 per cent, so workers will have to become more productive. Some rise in productivity is likely, but it’s not clear that it can comfortably grow at a rate as high as 3 per cent. If growth is closer to 2 per cent, inflationary pressures will build. This will certainly worry the Fed, which is charged with keeping inflationary pressures in check.
Delicate balancing act
The new chairman of the Fed, Jerome Powell, has overseen his first meeting of the board of governors, and has provided an updated set of projections for the US economy and monetary policy against a backdrop of looser fiscal policy.
One might have thought that the Fed would have voiced concern about the risks of overheating posed by the administration’s fiscal stimulus, and have expressed a need for much more contractionary monetary policy. In fact, changes to the Fed’s plans for normalising interest rates have been quite modest. Perhaps Powell has chosen to tread carefully. In the coming years he faces the need to maintain a delicate balance between retaining his credibility with financial markets and not upsetting an unpredictable administration.
He will at least find solace with other central bank chiefs, whose ambitions to normalise policy are also likely to be complicated by government interference. The ECB is increasingly worried about inflationary pressure building in Germany. However, unemployment in Italy, Spain and France remains well above pre-crisis lows, particularly among younger people. How will ECB president Mario Draghi – or whoever succeeds him in October next year – balance these competing interests?
Meanwhile, the Bank of England’s life is greatly complicated by Brexit uncertainty. Higher interest rates could create domestic anxiety that will only add to the challenges facing prime minister Theresa May in coming months.
These near-term strains on the relationships between governments and central banks might well pale in comparison with the challenges that will come as governments struggle with the fiscal demands of ageing populations. Meeting the pension and healthcare expectations of a rapidly greying electorate is likely to push government debt ever higher from the already lofty heights seen today.
The bigger the debt, the more it costs to service it. The UK government already spends almost £40 billion a year on interest payments. The UK’s fiscal watchdog, the Office for Fiscal Responsibility, believes that each percentage point rise in short-term interest rates will raise debt interest costs by a further £5.5 billion. Clearly, servicing ever-rising levels of government debt will be easier with an obliging central bank.
Ultimately, many of the structural forces that gave rise to the 35-year bond rally are still in place today: weak worker bargaining power and downward pressure on prices arising from new technologies, for example. That said, markets may start to wonder whether globalisation will be reversed as politicians in the West focus policymaking on workers who have been ‘left behind’. Markets might also start to question whether central banks are truly operationally independent.
If so, investors will want to be compensated for additional inflation risk, which could put upward pressure on longer-term interest rates. Is the great bond rally set to reverse? Perhaps not. But the risk is rising.
Karen Ward is chief market strategist for the UK and Europe at JPMorgan Asset Management.
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