3% inflation won’t cause a bond collapse, says James Lynch

by | Mar 1, 2021

UK inflation could spike as high as 3% this year as the impact of higher commodity prices and base effects feed through the system, but it won’t cause a bond market collapse, says James Lynch, fixed income investment manager at Aegon Asset Management.

Inflation has been subdued for a number of years, with deflation a more real threat, but as economies recover from the pandemic, the wave of stimulus pumped into the global economy is expected to generate higher prices.

According to Lynch, inflation in the UK could breach the 2% mark, and potentially go as high as 3%. Rising inflation is negative for bonds, particularly with yields as low as they currently are, but Lynch believes it will not cause a collapse in the bond market because the root causes of higher inflation are temporary, and will not prompt action from central banks.

“Inflation could go to a 2% to 3 % range, rather than a 1% to 2% range, but this is not a materially higher new level,” he said. “It isn’t going to get out of Central Banks’ control, and while there may be a sharp bout of higher inflation driven by shortages during 2021, it is not likely to be sustained.”

As the inflation is likely short-term, Lynch says central banks will not be forced to raise rates, and thus will not cause ructions in bond markets. “Central Banks are not going to rock the boat,” Lynch says. “Rates are unlikely to move higher until we are well into the recovery, and developed market central banks won’t blink twice at inflation of 2% to 3%, especially not when GDP is still below 2019 levels.”

“Economies need a huge GDP expansion to get more people working as quickly as possible. Once in a more stable position and with demand-side inflation appearing, Central Banks will begin talk of tightening to prevent a different kind of demand driven inflation, but that is some way off.”

Drilling down into the current causes of inflation, Lynch says supply-side issues and base effects, both short-term issues which are rectifiable, will cause the temporary spike.

“Shortage in supply could be remedied easily in sectors such as hospitality when it opens back up,” he says. “While we may see some year-on-year anomalies in pricing, the idea that this sector will see sustained inflation is fundamentally flawed.

“As far as base effects go – oil dropped to $20 last April, and at the time of writing we are around $64. Inflation will go higher thanks to this, but this is something the market already knows.”

Many commentators believe that the vast sums of money being pumped into the system and the massive savings piles that are ready to be spent will also contribute to higher inflation. However, Lynch argues that much of that money is merely replacing wages people would have been paid had there been no pandemic, and therefore this is not excess demand.

“A one-off destruction of people’s earning capacity over a prolonged period has very broadly been replaced through printing money. Put simply, the money being put into the system is plugging a hole in the economy, not adding to it.”

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