Treasury yields and inflation expectations: the key to 2021

There is a growing school of thought that the combination of pent-up consumer demand and stimulus will lead to a surge in inflation, with longer term government bond yields moving higher in anticipation. How far these markets go and the way that central banks respond will have a huge impact on the performance of the different asset classes. 

Interest rates have been kept at artificially low levels ever since the global financial crisis of 2008, with central banks actively anchoring bond yields via their policy of quantitative easing (QE). This involves monetising a large proportion of the sovereign debt by buying government bonds, which bids up the prices and forces down the yields. 

The policy has had a massive effect and by the start of November 2020, just before the approval of the first coronavirus vaccine, there were bonds worth $17.05 trillion – a quarter of the world’s investment grade debt − trading with a yield of less than zero. Investors who bought at these levels were guaranteed to make a small loss if they held them to maturity, but they were still willing to do so because inflation wasn’t considered to be a major threat. 

It is hard to believe, but in 2020 the Bank of England acquired £290bn of UK government bonds (gilts) out of a total net issuance of around £360bn. After more than a decade of expanding its balance sheet the central bank now holds approximately £739bn of gilts, equivalent to 35% of the national debt.

Spending during the pandemic has pushed public sector debt in the UK close to 100% of GDP, a level last seen in the 1960s when it was on the way down following the Second World War peak. In the US, where the Federal Reserve has been just as active supporting the huge bond issuance programme, the ratio is over 100%. 

The return of inflation

Low yields in the face of such a rapidly increasing money supply were only possible while inflation remained subdued, but things have changed dramatically since the approval of the first coronavirus vaccine in November. 

Many economies are now re-opening and the sheer magnitude of the economic stimulus – the recent $1.9 trillion package approved in the US is equivalent to ten percent of GDP − has led to an increase in inflation expectations. These have been further boosted by statements by the Fed and the Bank of England that they will allow their economies to run hotter than they would have in the past. 

It seems likely that the pent-up demand caused by the lockdowns will result in a surge of consumer spending when economies re-open as people eat out, go to see shows and films and start to travel again. The huge fiscal stimulus packages that put money directly in people’s pockets should virtually guarantee it. 

Jerome Powell, the chair of the Fed, has acknowledged this, yet has said that the resultant increase in inflation would only be transitory. He has also stressed the importance of getting back to full employment and said that they ‘are not even thinking about thinking about raising interest rates’. 

Rising yields

Of course we all know that the government is desperate to get some inflation back into the system to ease the real burden of the debt. However, it can only afford for yields to go up slowly, otherwise the premature tightening could choke off the recovery and put too much of a strain on the public finances. 

A mere one percent increase in yields would add £20bn a year to the UK’s cost of financing the debt, which is why the moves in the government bond market are so important. The ten-year UK gilt yield has recently risen to 0.79%, from 0.2% at the start of 2021 and is now trading back above pre-pandemic levels. 

It is a similar picture in the States where the ten-year yield has climbed to 1.7% from 0.5% at the trough in August last year. The yield curve has also steepened – the difference between the yield on the two-year and ten-year has increased – a classic indication of rising inflation expectations. 

Rising bond yields pose a major threat to monetary policy, as if the markets raise interest rates prematurely it would put borrowers under pressure. The huge levels of debt make individuals and companies, as well as the government, much more sensitive to small changes in interest rates and inflation, which means it wouldn’t take all that much of an increase to create a serious problem. 

The different scenarios 

There are a number of ways that this could play out, with the most benign scenario being a more muted version of what we have seen to date – slowly rising inflation expectations and yields creeping higher, but not enough to spook the markets. This would see the rotation out of growth stocks in favour of cyclical value companies continuing as economies recover, with bonds remaining under pressure. 

If inflation expectations pick up more quickly and yields spike higher, it could create panic in the markets and trigger a cross-asset sell-off as investors anticipate higher interest rates. Longer duration securities like growth stocks and bonds with a long time to go until maturity would suffer the most, but the carnage would be pretty widespread. 

A more optimistic possibility is that central banks would step in and increase their bond buying programme to suppress yields as we have seen recently in Europe. They could even start buying longer dated bonds, which would be a controversial move and represent yield curve control. If this was the case, the resultant fall in real (inflation-adjusted) interest rates would propel assets like gold, bitcoin and others much higher. 

Be prepared

It could all happen really quickly because of the way that inflation is calculated. The annual rate is worked out by measuring the consumer prices index (CPI) each month and then looking at the percentage change from twelve months earlier. 

In the US the consumer prices index fell in March, April and May 2020 because of the impact of the pandemic, before it then started to increase again. This is important because it affects the calculations for the next few months. 

The latest annual rate of change for the year to February 2021 is 1.7%, which is below the Fed’s two percent target, but even if prices stay static, the March reading that comes out on April 13 would rise to two percent and the April reading would be 2.7%. 

Some analysts believe that the actual increases will be much higher, with the annual rate of change in March being three percent or more. If this happens it could send the market into shock, with bond yields spiking higher unless the Fed steps in and calms things down. 

Bitcoin

Bitcoin is the oldest of the world’s crypto currencies and has risen dramatically in value. It started 2020 at $7,500, but has now gone on to trade in excess of $50,000. 

Crypto is designed to act as a decentralised payments system that enables people to transfer value without the need for financial intermediaries like banks. Unlike the normal paper currencies the supply is limited and cannot be affected by government agencies.

Because of this some argue that Bitcoin is the digital equivalent of gold and will do well as the authorities continue to increase the money supply via QE. It has a 21 million supply cap, which is where the value comes from, but as it pays no income it is essentially worth what someone else is willing to pay for it, hence the huge volatility. 

Bitcoin has many staunch adherents who believe that there will be a wall of institutional money flowing into it that will propel the price much higher. There could also be more retail interest following the creation of several Bitcoin ETFs in Canada including Purpose Investment’s bitcoin (TSX:BTCC), as well as the application by VanEck to launch one in the States. 

Bitcoin is still relatively new and has crashed before, so it could all turn out to be nothing more than a huge speculative bubble. The authorities are in the process of creating their own digital currencies and could step in at any time to tighten the rules to put an end to the party. 

Gold and silver 

Gold peaked at over $2,000 per troy ounce last August, but has declined steadily since then and at time of writing had consolidated around $1,700 to $1,750. It is generally thought of as the best hedge against inflation, yet the clearest correlation is with real interest rates, as when these fall, gold tends to rise, as it did during the 1970s. 

If inflation picks up as looks likely and central banks intervene to keep bond yields and interest rates low it would be the perfect scenario for gold. One of the best ways to benefit from this would be Golden Prospect Precious Metals (LON:GPM), the £47m precious metals mining investment trust that is trading at a discount to NAV and which my colleague Simon Cawkwell has been advocating for some time.  

Gold mining companies amplify the movements in the spot price due to their operational gearing, with any increase in the value of the precious metal feeding directly into the bottom line. Many are currently making substantial profits even with gold at $1,700, and if it moves much higher the shares would experience heavy demand. 

If you would prefer an exposure to the gold price itself there are a number of bullion-backed ETFs available such a WisdomTree Physical Gold (LON:PHAU). Silver should also do well although it is more volatile and can be accessed in a similar way using an ETF like WisdomTree Physical Silver (LON:PHAG).

Other commodities 

Many commodities have rebounded strongly since the market sell-off last March as the roll-out of the various vaccines has paved the way for economies to re-open. Energy and metals prices provide good inflation-hedging characteristics as do the associated mining and exploration stocks and there is a good chance that they have much further to go. 

One of the key areas of the various stimulus programmes is infrastructure. If we see concerted action in the US, China, the EU and elsewhere to build back greener it would create a huge demand for raw materials like copper that make it possible to reduce our dependence on fossil fuels. 

The largest investment trust operating in the commodities sector is the billion pound BlackRock World Mining (LON:BRWM), which offers a diversified exposure to mining stocks with access to a number of themes including sustainable materials, electric vehicles and gold. 

At the end of January 39% of the portfolio was invested in diversified miners with the other main weightings being a 25% exposure to gold and 18% to copper. It is one of Winterflood’s recommendations for the year and pays an attractive yield of 3.5% that should improve as the underlying stocks increase their distributions. 

Another interesting option is the £100m Baker Steel Resources (LON:BSRT), which invests in a concentrated portfolio of unlisted natural resources companies. It is much riskier than its peer group because of the focused and unquoted nature of the holdings, but these assets could be incredibly valuable in an inflationary environment and receive attractive bids. The shares are currently trading on a ten percent discount to NAV. 

Value stocks 

Interest rates have been low ever since the global financial crisis of 2008 and this has helped to support long duration assets such as growth stocks whose projected earnings increase the further out you go. It has been a much harsher environment for higher yielding value stocks, but the rotation is already well underway and if inflation picks up without getting out of control it could go on a lot longer. 

In an environment of rising economic growth and inflation investors will be less willing to pay such a high premium for growth companies like the large tech stocks. This is especially true if rapid earnings increases can be acquired more cheaply via downtrodden value stocks operating in cyclical sectors like industrials, financials and consumer discretionary.

There are several value-oriented investment trusts in the UK that should do well if the trend continues, with a prime example being the £1.4bn Aberforth Smaller Companies (LON:ASL). Its portfolio of small-cap value stocks has struggled for years, but the shares have rallied strongly since the pandemic related sell-off last March and the discount has mostly closed. 

A larger cap alternative is Temple Bar (LON:TMPL), which has done well since the change of manager last year with a six-month gain of 76%, yet the shares still trade one percent below their NAV. Fidelity Special Values (LON:FSV) has risen 55% over the same period and is now trading close to its underlying value. 

An each way bet

Perhaps the most interesting of all is the nine billion pound Pershing Square Holdings (LON:PSH), which holds a concentrated portfolio of ten large, durable, US stocks such as Chipotle Mexican Grill, Hilton Worldwide, Restaurant Brands, Howard Hughes and Starbucks. The shares did extremely well last year, yet are trading on a 27% discount to NAV.  

Founder Bill Ackman has found a way to profit from a surprise rise in inflation and interest rates by buying protection against this potentially huge market-moving event. If rates go up as envisaged the policy would ‘make a lot of money’ and protect the portfolio in the same way that the contracts he bought ahead of the pandemic did in 2020. 

The key to the markets this year will be the extent to which inflation and government bond yields move higher. A sudden bigger-than-expected surge could trigger a widespread sell-off and force central banks to raise interest rates earlier than they would like, but if the increases are more manageable and they push back on the yields by changing their bond buying programmes it could be a boom time for commodities and value stocks. 

FUND OF THE MONTH 

One of the few investment trusts that would thrive regardless of whether inflation moves up gradually or jumps uncontrollably is the £500m Ruffer Investment Company (LON:RICA). This all-weather fund has been positioned for the return of inflation for years and is well-placed to profit from it. 

The managers have constructed a three-part portfolio to protect against all the likely scenarios, with the first element consisting of inflation-linked bonds, gold and a small allocation to bitcoin. These are designed to guard against higher inflation and financial repression, where inflation exceeds interest rates. 

Its second component is made up of unconventional insurance policies such as interest rate options and credit protections that should enable the fund to keep on course despite some potentially sharp market corrections. They had something similar in place last year that provided a solid floor during the sell-off in March. 

The other segment consists of value stocks from different countries that would benefit from the re-opening of economies around the world. It is an imaginative and unique combination that has delivered a share price return of just under 32% with low volatility in the year to the end of March and remains well-placed to prosper whatever the rest of 2021 has to throw at us.