Hermione Davies, investment director at Ruffer, believes investors are entering into a new world of inflation volatility and deeply negative real yields
Investors have divided into two camps. Those who believe inflation will subside and the rise in prices will prove temporary. And others who fear we are entering a period of high sustained inflation reminiscent of the 1970s. We consider both scenarios unlikely.
We believe we are entering a new inflationary era. But unlike the 1970s, it won’t be marked out by shockingly high inflation rates. Instead, investors will confront a world of inflation volatility. In this environment, the gap between interest rates and headline inflation will widen – creating a dangerous chasm known as negative real yields.
Take energy prices, wages and interest rates. Rising energy prices were chief amongst the culprits in sparking inflation in the 1970s as well as wage fluctuations. Today, wages are less likely to spiral, and while oil and gas prices have more than doubled in the last year, the world is not likely to see the ten-fold increase in energy costs that triggered the 1970s inflation.
Rather, the world economy today is more vulnerable to (and intolerant of) interest rate increases than it used to be. The government debt to GDP ratio for developed economies has risen from 20% in the 1970s to over 100% now. To put simply, governments have become addicted to zero-cost borrowing and cannot afford for it to increase. And with asset prices also anchored to zero rates, it looks impossible for modern central banks to raise rates much without sending shockwaves through bond and equity markets.
This is how negative real yields come into play. The latest US CPI release means that the Real Fed Funds Rate (the difference between headline inflation and the Federal Open Market Committee’s (FOMC) main policy rate) was below -6% in October. That’s lower than at any point in the 1970s. By this measure, monetary policy is even more accommodative now than it was back then. And potentially even more dangerous.
This is the defining trait of the next inflationary era. Not double-digit inflation readings like the 1970s, but deeply negative real yields – mixed in with a sizeable dose of inflation volatility.