InvestmentsDec 2 2021

The outlook for bonds after the pandemic

  • To understand the issues facing bond markets right now
  • To learn about the impact of higher interest rates on bond markets
  • To learn about conditions in the high-yield bond market
  • To understand the issues facing bond markets right now
  • To learn about the impact of higher interest rates on bond markets
  • To learn about conditions in the high-yield bond market
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The outlook for bonds after the pandemic

These are all first-order effects; factors that could directly push prices higher over a sustained period. But there are also second-order effects to consider, chief among which are inflation expectations. When an inflation shock happens it can cause consumers and businesses to adjust their expectations of future price rises. Left unchecked by central banks, this can become a self-fulfilling prophecy, as businesses raise prices to maintain their margins and employees demand higher wages. This process can be particularly powerful when several factors are in play simultaneously, as is currently the case.

Money supply growth remains high

Against this backdrop, central banks have continued to keep monetary policy loose, buying bonds and other financial assets and holding interest rates at historically low levels. These actions reflect the concern when the pandemic began that it would be viciously deflationary. Policymakers had to act fast to support the financial system by ensuring adequate levels of liquidity. In this regard, they have been effective. 

On a global basis, central bank liquidity has been the main driver for risk assets in the wake of the pandemic, with $17tn (£12.8tn) of credit created in 18 months.

While money supply growth has since fallen from its early 2021 peak, it remains historically high, even compared to the financial crisis. 

This is likely to continue to pass through to prices. A big difference between today and the period after 2008 is that, back then, while central banks used quantitative easing to try to grow the money supply, liquidity was being continuously drained as banks parked capital back at the US Federal Reserve to rebuild buffers and meet more stringent reserve requirements. Today, bank balance sheets are relatively healthy, so Fed stimulus has added substantially to the stock of money.

This means there is more of the extra liquidity in the system available for commercial banks to place in the real economy now, as much of the liquidity created in response to the global financial crisis had to be used by banks to meet regulatory requirements, but exiting the pandemic-induced recession, banks balance sheets generally retain more than the minimum required amount of capital, so have no need to retain any of the newly created cash. 

Couple this with supply bottlenecks and the reining back of globalisation and conditions are ripe for inflation being less transitory than some have hoped.

Do not fear the taper

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