Weekly Investment Update – A (Real) Riddle About G7 Government Bonds

It is not easy to revive a global economy

Restarting a stalled global economy is proving tricky. Untangling disrupted supply chains turns into a long-term reconstruction and overhaul exercise. Manufacturing capacity in China remains a potential source of further supply-side shocks if its zero Covid policy results in widespread shutdowns.

The recent surge in natural gas prices has revealed an unknown unknown: the potentially inflationary nature of the energy transition from fossil fuels to sustainable energy. Meanwhile, the risk of an excessively harsh winter lurks in the background – a known unknown.

And then there are the labor markets

Wage inflation would mean that latent inflationary risks were really igniting. It is only in the United States that this seems possible in the short term. Will workers return to the workforce now that the federal government’s pandemic-era benefit programs are being phased out? Will organized labor make a comeback with the help of Joe Biden in the post-Covid era?

From what we have seen so far, it does not appear that the reopening of schools and, in the United States, the removal of top-up unemployment assistance triggered an immediate increase in labor force participation. . And this despite record job offers. Anecdotal reports suggest that companies are already adjusting by paying to cover labor shortages.

And what exactly do we mean by transient?

Overall, it has become clear since September that US and global inflationary pressures are more than just temporary in the sense of a 3-6 month transition. The term “transient” is now interpreted to mean 12 to 24 months, possibly 36 months.

This is a period long enough to potentially de-anchor inflation expectations from the central bank’s inflation targets, forcing monetary policy responses.

In short, the entire transitional thesis goes through a thorough stress test. Particularly in the United States where recent data suggests that inflationary forces are intensifying.

Speaking after the ECB board meeting on October 29, ECB President Christine Lagarde stuck to the narrative that the near-term rise in inflation is transitory. We would expect a similar message from Federal Reserve policymakers after the Federal Open Markets Committee meeting on November 2-3.

However, some central banks are responding to rising energy prices and supply bottlenecks. On October 27, the Bank of Canada surprised markets by announcing that it would halt asset purchases and raise interest rates sooner than expected. On the same day, Brazil’s central bank raised rates 1.50%, marking its biggest move in nearly 20 years.

The reaction of government bond markets

Sovereign bond markets in the United States and the euro zone have integrated this period of increasing inflationary pressure into higher breakeven points (see Charts 1 and 2 below). The prospect of higher energy prices weighing on growth prospects may partly explain the low / lower real returns.

The puzzles of the sovereign bond markets

Given what can be considered a drastic shift in inflation expectations, there are a number of puzzles:

In our view, the resilience of US Treasuries in the second and third quarters was, frankly, difficult to explain.. Why haven’t yields increased further?

Although the pace of the recovery in production and employment was perhaps a little slower than expected, there was every indication that this was due to supply side considerations rather than a shortage of supply. demand. In the meantime, these supply constraints were contributing to a surge in inflation.

Possible explanations include the following issues:

1. Overcrowded positioning in reflation professions
2. Limited net supply of U.S. Treasuries, as the Treasury pre-funded much of its financing needs in 2020 – meaning the Treasury was able to take advantage of a whopping $ 1.8 trillion cash balance at the Fed.
3. The rebalancing needs of US pension funds to the detriment of equities, in favor of US Treasuries
4. Massive purchases of US Treasuries by banks given weak growth in their loan portfolios and launch of new repo facilities for New York Federal Reserve brokers
5. Relatively high returns hedged in currencies on treasury bills for international investors.

Why are real returns so low?

The decline in real yields this summer could be due to investors’ reaction to the prospect of inflation by buying inflation-linked bonds. Not necessarily the optimal hedge as detailed in this article.

In the short term, the yields of inflation-linked bonds are determined by the instantaneous revaluation of real yields. The held-to-maturity linkers will offset realized inflation as it occurs during the life of the bond through a slow process of increase.

Real Returns – A Negative View of Growth Prospects

Pessimism about longer-term growth prospects may be reflected in low real returns. Rising energy prices only add an additional drag on growth (the stagflation “stag”).

US GDP data released on October 29 shows that the economy grew only 2% annualized in the third quarter. This figure was lower than consensus expectations for 2.7%. This is a significant slowdown from the 6.7% pace recorded in the second quarter. Likely explanations include the negative impact of the resurgence of Covid cases and lower demand due to higher inflation caused by supply chain issues.

And lower longer

Demographics are reversing in a number of countries (notably China), savings rates are likely to decline over time, and pension and health systems will deplete resources. In addition, the potentially inflationary nature of the energy transition from fossil fuels to sustainable energy is now integrated into the equation.

Trend economic growth will slow further given demographic trends, but economies may well perform closer to full capacity. Policymakers could be encouraged to reduce the heavy debt burden through an inflationary tax. Central banks will have the heavy task of controlling its level.

As inequality has made austerity politically unacceptable and real yields must be suppressed for reasons of debt sustainability, central banks may have to remain the marginal buyers of public debt.

The risk is that at some point, this monetary seigniorage devalues ​​certain currencies and contributes more to inflationary pressures in certain economies.

All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different opinions and make different investment decisions for different clients. The opinions expressed in this podcast do not in any way constitute investment advice.

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