Two key factors that have shaped the global economic landscape over the past several years are changing. Each points in the direction of falling government bond prices and rising yields.
The first big change is the “end of deflation” – or at least the end of fears of global deflation. Inflation in developed economies has not risen much higher than 1 per cent in the past three years, and has been zero or negative in several countries recently due to the fall in energy prices in 2015. But the dollar price of oil has risen by more than a third since the start of this year and headline inflation rates are set to rise with it.
This effect is going to be turbo-charged in the UK due to the inflationary effect of the fall in the value of the pound. The sterling price of oil has risen by more than 100 per cent this year and we can expect rising import prices to feed into higher inflation now for at least the next 18 months.
And it is not just commodity and exchange rate changes that are pushing up inflation. For the first time in several years we are also seeing wages and other domestically generated costs creeping up, not just in the UK but, most importantly, in the US too.
As a result, forecasters expect US and UK consumer price inflation to be running significantly above 2 per cent by early 2017 and to keep rising for much of the year.
Does this mean we are heading back to 1970s style inflation? Hardly. By any historical standard, we are still living in a low-inflation, low-growth era and interest rates are likely to stay low to reflect that.
But it does mean that financial markets in the coming months are likely to be much less concerned by the fear of falling prices. It also means we should expect the US central bank to move ahead with modest and gradual interest rate increases over the next year.
Not everyone is in the same boat. The eurozone will also see inflation move up sharply in the next few months, from zero to close to 1 per cent but that is entirely due to rising oil prices. Both the eurozone and Japan still have a long way to go to reflate their economies, and neither is expected to see 2 per cent inflation any time in the next three years.
There is no debate in the European Central Bank and the Bank of Japan about raising interest rates. Rather, the fear is that these central banks are not doing enough to get back to 2 per cent before the world heads into another recession.
This brings me to the second big change in the global economic landscape: a widespread feeling among investors and policymakers that extreme monetary policy is reaching the end of the road.
There has been much debate this year about the effectiveness of negative interest rate policies but most would admit there is a limit on how low short-term policy rates can go. It is particularly problematic if extreme monetary policy leads to a flat or even falling yield curve, with long rates close to or even below short-term ones.
A flat yield curve makes it difficult for banks to make money lending to businesses and households, even though that is exactly how loose monetary policy is supposed to stimulate the economy. A prolonged period of super-low long-term interest rates might also encourage baby boomer households to save more – not less – in order to achieve the same cash return.
Hitting the limits
To be sure, low bond yields have also had positive effects – particularly for eurozone governments, which have been able to channel money saved on government debt interest into higher public spending elsewhere. That, in turn, has supported the eurozone economy and led fiscal policy in 2016 to be broadly stimulative for the first time in a while.
This may hint at a new future for monetary policy, where central banks’ key role is not to push down the cost of borrowing as far as it can possibly go but merely to hold long-term borrowing costs at low enough levels to make expansionary fiscal policy affordable.
To say this explicitly is probably a bridge too far in the eurozone, particularly for Germany. But policymakers in Frankfurt and Tokyo are recognising that pushing up government bond prices can only take you so far.
The crucial takeaway for investors is that we should not expect capital gains on bond holdings to compensate for low interest rates in the future, as they have in the past. People have been predicting a turn in the bond market for several years, only to see bond prices reach new highs. But in the last few years inflation was heading down, not up, and policymakers still believed in the transformative power of extreme monetary policy. This time it really does look different.
Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management