end of the bond party could get violent

Gatemore Capital Management's Liad Meidar looks at the dangers of inflation around the corner and what this could mean for the unsustainable bond party.

end of the bond party could get violent

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Clearly there are many investors who are approaching the bond market thinking the glass is half full – in reality, there are merely a few drops left in there.

Their logic is simple: growth has slowed down (once again), inflation is in check and Japan has now jumped head-first into the quantitative easing (QE) party – so keep buying bonds while the music is still playing.

The problem is that the music must stop at some point. When it does the effect could be violent.

Central banks around the world have embarked on unprecedented levels of QE and many believe that this could end in a "ketchup in the bottle effect" – imagine persistently tapping the bottom of a glass ketchup bottle until the ketchup finally bursts out at an unstoppable rate.

QE programmes were launched in response to the plummeting of the money multiplier following the financial crisis. If (or when) those programmes succeed, the money multiplier will rise again, resulting in uncontrollably fast monetary growth.

At that point, central bankers will have to make the difficult choice between sustaining sharply higher levels of inflation or sacrificing a fledgling recovery. In anticipation of this dilemma, central bankers have been circulating academic papers about the virtues of targeting nominal GDP rather than inflation.

Anyone buying a long-dated bond today is betting on their ability to anticipate ahead of all of the other players in the game when the music will stop. A better path for investors is to reduce interest rate duration and maintain exposure to inflation-linked assets.

Commodities and real assets have performed well in inflationary environments historically, and are an integral part of a diversified portfolio. The stakes are high, and who knows how many chairs will be left this time.

 

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