What Next For The Bond Market?

A lot of people, especially some of the economists, feel that inflation is structural in nature. In case inflation tends to be more sticky or tends to be more aggressive and violent, that could affect the bond market.

One has to remember that for the last decade or more, the single cause of the rally in global equities has been in bonds. So, if the bond market has been vertically downward for almost 12-13 years, in equity markets there is a very good inverse correlation on a decadal basis.

So the big risk to the market is obviously going to be bond yields but in all these problems the one thing that we keep noticing every morning is that the bond yields have been fairly well behaved.

The key thing to remember here, though, is that bond prices go up when interest rates go down — and that interest rates tend to go down when inflation goes down. For the past 40 years or so this has been the main dynamic in the market.

Falling inflation, falling rates, rising bond prices. But something has very obviously changed. Inflation is rising.

The latest numbers in the UK put it at 3.2% and it is no longer considered completely nuts to talk of it hitting 4% before the year is out. You can argue that this is transitory, but it has already persisted for rather a long time, for something as temporary as the world’s central banks insist it is. That suggests that it is well on time for the whole thing to reverse.

Rising inflation, rising interest rates, falling bond prices. If so, you will want to get out of the bond market as fast as you can. But here’s the thing: the end of a bull market, in either bonds or equities, doesn’t necessarily mean that a bear market will immediately follow.

There are a variety of things that can happen from here. Inflation could turn out to be transient, in which case we could see a scenario where all the money has been made, but a real bear doesn’t start.

Inflation could rise, in which case we could see rates rise fast and bond prices collapse. Or we could see high inflation but low interest rates, or at least interest rates kept well below inflation, nonetheless. The latter is most likely. Why? — debt.