is the bond market calm over inflation justified?

This article covers ground we have not got to yet, but a lot of it is around material we are covering - namely inflation. Come to me if some of it is not self-explanatory:

When everybody depends on a bull market, they all run with the herd

Louise Cooper

Are mainland Europe and Britain, therefore, set to experience Japanese-style deflation? To find the answer, many look to the bond markets 

Yuriko Nakao/Reuters

 

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  Are mainland Europe and Britain, therefore, set to experience Japanese-style deflation? To find the answer, many look to the bond markets  Yuriko Nakao/Reuters

Last updated at 12:01AM, November 11 2014

Last Friday I had lobster risotto for lunch. James Carrick, an economist from Legal & General Investment Management, who was dining with me, chose beef. He did so because he had eaten beef recently in the Goldman Sachs dining rooms and had enjoyed it immensely. The memory of that experience influenced his menu decision. The same thought process may partly explain bond market mentality on inflation.

The Bank of England issues its latest quarterly Inflation Report tomorrow. Since its last update in August, there has been yet more evidence of prices stagnating. Consumer prices rose by 1.2 per cent last month on last year’s level, down from 1.5 per cent the previous month. This is the lowest CPI figure for almost five years and inflation has been lower in only two years out of the past thirty. The latest eurozone inflation figure for October showed prices rising a mere 0.4 per cent on their 2013 levels. Prices are falling in Greece, Poland, Portugal, Spain and Sweden. Eurozone inflation has been lower only in the depths of the financial crisis and only then for a few months.
Are mainland Europe and Britain, therefore, set to experience Japanese-style deflation? To find the answer, many look to the bond markets. Bonds are regarded as being the great predictors of inflation because high inflation cuts the value or burden of debt substantially. Bond prices are highly sensitive to inflation expectations.
In 1998 the government had to pay an interest rate of almost 6 per cent a year to borrow money for ten years. Today, the government pays just over 2 per cent a year. In 1999, according to BSkyB’s annual report, the satellite television company paid between 6.8 per cent and 8.4 per cent a year to borrow for ten years. Recently, it borrowed billions by issuing bonds, paying a mere 3.75 per cent for ten-year debt. Companies and governments are paying extraordinarily low interest rates in the bond markets to borrow.
Yet since 1989 CPI inflation has averaged just below 3 per cent a year. If inflation returns to this level, then anyone lending to the government receiving interest of only 2.2 per cent a year will get less back than was originally borrowed in real terms. The investors who lent BSkyB cash at 3.75 per cent are getting only a tiny amount more than historical inflation of 3 per cent. That is very little compensation for the risk of lending to the company. Thus many conclude that the only way that these extraordinarily low interest rates can be justified is by assuming that inflation will be low for many years.
Yet there are reasons why bond markets may be poor predictors of future inflation. The first is what Mr Carrick and I have dubbed the “beef goggles” effect. Or, as applied global macro research puts it, we humans are “tainted by the past” — in James’s case, a delicious beef past.
Bond markets have “memories”, which explains why interest rates on bonds were so high in the early 1980s. Bond investors were scarred by the high inflation of the 1970s. The implication of this research is that at the moment bond-buyers believe that inflation will remain low because it has been low in the recent past. The behavioural finance term is an “availability heuristic”, which overestimates the likelihood of events with greater “availability” in memory.
However, there are other reasons why bonds may be poor predictors of future inflation. These markets have been heavily manipulated by $3.5 trillion of bond-buying from the Federal Reserve and £375 billion from the Bank of England. The European Central Bank may not have indulged in full quantitative easing, but Mario Draghi, its boss, has talked bond prices up and rates down since his “whatever it takes speech” just over two years ago.
By default, bond fund managers have to believe in low inflation to own bonds at these interest rates and keep themselves in work. If bonds are not paying enough even to keep up with future inflation, why own them and employ a bond fund manager?
Moreover, after a 20 to 30-year bond bull market, there are also not many money managers, bond traders or brokers working in the markets that have experienced a crushing bear bond market resulting from high inflation. It suggests that the market, effectively just a group of individuals, is underestimating the threat.
And the biggest sign that bonds are at the peak and overvalued? That bond fund managers, the likes of Bill Gross and Mohamed El-Erian, are the superstars of the money management industry.
Beer goggles improve the attractiveness of a possible mate while under the influence of alcohol. Beef goggles improve the appeal of bonds while under the influence of the euphoria of a multi-decade bull market. It is possibly unwise to wear either too regularly.

Two’s company, but three’s a crowd
There has been some criticism of Mario Draghi, president of the European Central bank, on his management style. Perhaps controlling a 24-member council, governing 18 member states in the aftermath of a global financial crisis, requires a rather authoritarian approach to get anything done.
Yet a quote buried in a Reuters report grabbed my attention. An unnamed source says that Mr Draghi pays little attention to national central bank governors’ comments in the regular rate-setting meeting: “He sits there with these three mobile phones in front of him and sometimes he’s sending text messages or going out to make or take phone calls.”
Most people I know have two mobile phones — one for work and one for personal use. I cannot think why Mr Draghi requires three mobiles. Is he a spy? Has he got a sideline as a headhunter and needs an extra throwaway pre-pay mobile to persuade staff to break their employment contracts? Any suggestions?
Louise Cooper is a financial analyst and Goldman Sachs alumna. Follow her on @Louiseaileen70