Bonds, Inflation, Interest Rate Policies

At the end of 2014, beginning of 2015, I believed that a bubble had formed among European bonds that would soon burst, on the model of the 2003 Japanese/American bond markets. Indeed, concerns were the same: the developed countries, especially European countries, seemed to be trending toward a deflationary spiral. Instead, it turns out that core inflation in the G7 countries had remained very stable around 1.5-2% through the period.

Actually, it seems that even the Great Crisis of 2008-2009 did not change much of this trend: obviously, the financial crisis caused a deflationary pressure, but with their interventions, central bankers were able to intervene and generate sufficient inflation to combat this deflationary trend. As a result, from an overall inflationary perspective, we seem to have entered into a new period of relative stability. Now, the big question obviously is what will happen with markets when Europe, the U.S.A and even Japan are expected to embark on a path of moderate growth? It could be that there will be no impact and that we will stay at the same level of (core) inflation of 1.5-2%. But it could also happen that the central banks have maintained their inflationary pressure too long and that slight inflationary spikes could start being reported. Of course, at the time when German sovereign bonds hovered around 0%, they reflected unrealistic market prices, but now this situation has clearly changed. When an average European 10 year bond yields around 1.5% (versus 0.6% just a few months ago), it is clear that market expectations of rate changes must have changed radically. Indeed, an average 1.5% yield in Europe for the next 10 years is quite plausible, with close to zero yields in the first 1-2-3 years, followed by yields averaging 2% in the subsequent 7 years, a modest but not so unrealistic level.

Of course, the big question is whether the ever tightening German and American workforces might cause pressure on local wages in the future. If so, the Fed would certainly have to raise rates, but the ECB would find itself conflicted between Germany on one side pushing for rate increases, versus southern member states pushing for a continuation of low interest rate monetary policies. As a result, we predict that the European QE program will have to be abandoned earlier than planned, but it is unlikely that rate hikes would follow for quite a while in the Eurozone for fear of their economic consequences.

Overall bond yields grew in 2003 by 1-1.5%, whose impact has faded for the most in 2015: bond yield moves are likely to remain behind us, although mild aftershocks might still be experienced, should news of surprising higher economic growth or inflation spikes be reported.
It is important to notice, however, that concurrently with the passing of the effect of the 2003 bond yield rise, a stock rally has started to develop. Our expectation is that this rally will be sustained for the foreseeable future.