by Simon Gauci Borda
In recent weeks, one of the main talking points within financial circles has been the rise in inflation and its effects on the value of financial assets. After many years of substantial efforts by monetary and fiscal authorities to prop up inflation with little to no success, the sudden rise in inflation, and more importantly the expected rise in inflation, has been one of the main concerns within financial markets.
Inflation data released by both the U.S. and Germany show that inflation is on the rise. In fact, during the month of January, inflation in the U.S. rose to 0.40% compared to the prior month’s 0.2% while Germany’s inflation during the same month was that of 0.80% with the prior month also showing similar levels of inflation. The expected rise in inflation during the current year seems to be having a greater impact on financial markets as the U.S. is expecting inflation to rise to 2.1% while inflation in Germany is expected to rise to 1.6%.
Due to the rise in inflation and inflation expectations, the yield on the U.S. Treasury has risen from 0.91% at the start of the year to its current 1.34% while German Bund yields have risen from negative 0.57% to their current yield of negative 0.31%.
The recent increase in inflation and inflation expectations can be explained by a couple of key factors. The decline in economic activity brought about by the pandemic has resulted in a substantial increase in government spending while central banks have not only left interest rates at record lows but also increased the size of their bond buying programmes to assist both the financial markets and the real economy. The actions taken by fiscal and monetary authorities has resulted in an increase in the supply of money which should naturally increase the level of prices on goods and services.
However, two other factors might better explain the recent rise in inflation and inflation expectations. The positive news on the vaccine rollout, particularly in the U.S., has played a significant part in the rise in inflation expectations. The vaccine rollout is expected to release consumer’s pent-up demand which should lead to a rise in consumer spending and in turn an increase in the prices of goods and services purchased.
From a bond holder’s point of view, inflation erodes the purchasing power of a bond’s future cash flows. The greater the level of inflation together with higher expected future rates of inflation will result in higher bond yields as investors demand greater returns to compensate for the higher rates of inflation. Naturally, the higher bond yields demanded will lead to a loss in the value of bonds given the negative relationship between bond prices and their respective yields.
Given this scenario, bond investors may use certain measures to mitigate the effects of rising inflation. One such tool is the use of inflation linked bonds. The coupons and principal paid from holding an inflation linked bond are both tied to an index which tracks the value of a certain basket of goods and services. Naturally, as inflation picks up the coupons and principal amounts paid on inflation linked bonds should also rise.
Another tool at the disposal of bond investors are floating rate bonds. The coupon paid on such bonds is based on a certain benchmark level of interest, usually the inter-bank markets, plus a nominal rate of interest. In an environment of rising inflation, which should lead to a rise in interest rates set by central banks, the amount of interest paid to investors holding floating rate notes should also rise.
While investors may find it difficult to anticipate future levels of inflation and its impact on their investments, they should nonetheless keep a watchful eye on inflation in the context of their overall portfolio whilst being wary of the tools at their disposal which will enable them to protect the value of their holdings in an environment of rising inflation.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.